7 Reasons Why Fundamental Analysis is Crucial

I strongly agree with the fact that fundamental analysis is crucial since it identifies highly financially sound companies that will succeed in the long-term. For instance, examining Apple’s ROE, which was more than 10% above the industry average from 2006 until today, has shown smart investors that the company was utilizing its low capital well and would lead the market after launching its iPhone.

In addition, during the downturn of 2008, those assessing Wells Fargo’s liquidity ratios that were 2-3 times better than many other players could invest with surety as the bank recovered quickly and continued paying dividends . Therefore, financial analysis highlights that the value of a security is determined by distinct characteristics rather than mere market trends.

7 Reasons Why Fundamental Analysis is Crucial

Assessing Company’s Financial Health

Understanding the financial health of a company is absolutely important for investors trying to make informed decisions. A classic example is the assessment of Apple Inc.’s financial comeback in the early 2000s. After years of performance struggle in the late 90s, Apple’s financial statements recorded a comprehensive improvement after major innovations and entry into new markets by delivering first the iPod and later the iPhone . Higher revenues, more favorable profit margins, and sizeable cash reserves became standard for Apple’s operations by the early 2000s; this change facilitated investments in the company.

When evaluating the financial health of a company, the process starts with analyzing its financial statements. Typically, the balance sheet, income statement, and cash flow statement are studied, and they provide critical data regarding a company’s assets, liabilities, revenues, expenses, and liquidity. For example, a desirable condition that indicates that a company is performing well with respect to its financial health is a pattern of consistent growth in revenue and high profit margins. A real-world example of this is Amazon.com, Inc. , which has recently demonstrated that in the last few years, it has followed the path of growth thanks to its steady increase in revenues related to the development of various aspects of Amazon, including Amazon Web Services and Amazon Global.

Another important source of easily accessible information is financial ratios that provide a quick assessment of a company’s stability, efficiency, and profitability. The most important ratios include the debt-to-equity ratio, current ratio, and return on equity. For example, a low debt-to-equity ratio may mean that a company is less likely to suffer during an economic crisis because it is not highly dependent on loans. Perhaps the third factor affecting the health of potential investments is industry news, which might provide little value currently embedded in a company’s financial reports. For example, the announcement by Microsoft that it would provide cloud services in the future was reported as good news for investors when the technology giant’s stock grew constantly in value.

Evaluating Management Efficiency

Evaluation of reliability of a company’s management is important because it affects the company’s strategic decisions, and as a result, the financial position of the company. One example from history is Louis V. Gerstner’s work at IBM . Worth noting, the stock price rose during his tenure, and he was able to shift IBM’s focus from hardware to software and services, which was so necessary in the 90s.

The decision-making speed and efficiency can be assessed as a sign of efficient management. For example, Netflix, being a company focused on DVD rental service, quickly switched to streaming services under the leadership of Reed Hastings. They understood the rapid expansion of broadband and the change in customer preferences for slower cassette rentals. Broadband expansion has significantly increased the growth rate of Netflix subscribers, increasing profit and popularity.

Operational efficiency is also significant, including effectiveness of cost management and operation workflow. A prominent example is the work of Tim Cook to improve operational efficiency at Apple . He worked on cost management and managed to make the supply chain significantly more efficient. The relative difference between production costs and revenue has been continuously declining as Apple expands product lines.

Analysis of crisis shows how efficiently management is able to respond. The handling of the Covid-19 pandemic by the world’s leading airlines is an example. Delta Airlines, shown by CEO Ed Bastian, quickly reduced route capacity and received emergency funding. Delta Airlines has resolved the crisis much more efficiently than many of its competitors . You can receive relevant information by reading executive reports and transactions and studying the company’s announcements. CEOs provide relevant information during earnings calls.

Predicting Long-Term Growth

Predicting long-term growth using fundamental analysis requires specific metrics and historical data to forecast what the performance of the company is going to be in the future. For instance, Amazon has demonstrated exceptional revenue growth of a CAGR at around 28% from 1997 to 2017. This can be attributed to the effectiveness of the company at scale and its adaptability to the developing e-commerce and cloud computing market.

Similarly, Google has maintained a significant CAGR in the advertising revenue category. From 2010 to 2020, the CAGR of the company’s advertising revenue was at about 19%, which showcases that despite the company’s prominence and the possible slowdown in growth, its position in digital advertising spaces is going to remain strong, which is a significant metric for investors interested in long-term, stable returns.

Regarding Tesla, the annual revenue growth of the company accelerated from around $204 million in 2010 to approximately $31.5 billion in 2020. This difference results in CAGR growth of approximately 57%. It showcases that a company’s long-term trends do not only result from vehicle sales. It also shows the importance of the expansion of the applicable customer base and further product diversification for long-term growth of the company.

Apple’s continuous investment in R&D from around 2.4 billion in 2010 to around 18.75 billion in 2020 also showcases its intentions for the long-term growth of the technology sector. It is also relevant to mention high-profile acquisitions by Facebook for the growth of the user base and purchase of Instagram for $1 billion in 2012 and WhatsApp in 2014 for $19 billion, which also showcases a long-term growth strategy.

Comparing Industry Peers

One of the most important aspects of fundamental analysis is understanding the competitive landscape. It allows investors to identify leaders and laggards and, accordingly, make more informed decisions with regard to investment opportunities. For example, the electric vehicle market analysis shows that three EV producers – Tesla, NIO, and Rivian – pursue different growth strategies in terms of technological advancements and market penetration . In order to compare industry peers, investors often begin with benchmarking financial metrics, such as revenue growth rates, profit margins, and return on equity . When comparing the ROE of Coca-Cola and PepsiCo, I would note that both companies have similar patterns of operational efficiency and similar levels of financial leverage .

These features are logical due to the firms’ narrow economic moats and relatively similar markets . Market share analysis, in turn, shows the percentage of cloud computing or personal computing markets that are controlled by Microsoft, Apple, or Google. Product innovation and market expansion comprise additional elements of comparing industry peers. I could use the example of Adobe, as one of the companies first to adopt the shift from its traditional business model of selling perpetual licenses to the subscription model . As a result, Adobe gained more market share and revenue predictability than Corel.

Finally, external reports and ratings could be used to compare companies. Both Bloomberg Professional and Betaqube would provide financial information, analysts’ ratings, and future forecasts, including growth rates and shortage or turmoil signals. Market shares and personal computing space could be relevant examples of sources, as they might contain mission-specific information and recommendations in the cloud or personal computing industry.

Checking Debt Levels

Understanding the levels of the company’s debt is a critical part of an evaluation of the latter’s financial condition and risk. Netflix might be a vivid example of how debt can affect business. Owing to an increase in the investment into content for the company’s platform, Netflix’s debt levels have soared. However, the use of such financing to drive growth in subscribers and other performance indicators was crucial for the company to prosper. Correspondingly, the strategy achieved positive feedback and was followed by a significant jump in Netflix’s stock price and market cap.

In terms of evaluation of the company’s debt levels, assets and liabilities ratios, including debt-to-equity, must be analyzed. This ratio indicates the proportion to which assets are financed by debt. A somewhat high rate of the ratio may threaten the organization’s condition in the case of an economic downturn. In 2008, when the financial crisis hit, many retail chains filed for bankruptcy, as they were unable to service the high debt levels they received. The interest coverage ratio is another crucial measure which demonstrates the business’s readiness to satisfy its interest obligations. In the capital-intensive telecommunications industry, the business typically needs to ensure that available before , and are high enough to cover the cost of the debt.

Short-term and long-term debt levels should also be analyzed. The evaluation of the maturity of the debt and the risk of its refinancing might be essential. During 2009, many financial companies such as Lehman Brothers, Merrill Lynch, and others failed because they had high levels of debt coming due that they were unable to refinance.

Understanding Revenue Streams

One of the most important factors for fundamental analysis is to realize the diversity and sustainability of a company’s revenue streams. A relevant example is the case of Apple Inc. The company started with producing Mac computers. However, several years later, Apple integrated music , smartphones , and services . All these innovations positively influenced Apple’s revenue and stabilizing its financial performance. In all four cases, revenue has increased proportionally to sales, yet securing the company on unstable conditions for a particular product – computers.

Many companies provide their revenue split by product or service defined as a revenue segment. For example, by the end of 2019, Amazon reported its revenue segments, e-commerce, AWS and other. A diverse product line helps investors to understand which business revenue stabilizes the company and which ones may contribute less to revenue.

Apart from the diversity, one should consider the growth of the revenue segment and revenue consistency. The greatest indicator of business sustainability is when specific segment revenues show consistent growth. Thus, a company is regarded as a growing and a flourishing business. For example, Google’s revenue growth in a core business of advertisements stabilized with the sale of hardware and service provision in the cloud segment.

Another characteristic, which must be considered is the geography of revenue. It is clear that the more international product reach gets, the better its revenue is. Besides, revenue cut by continent lowers the fall risk if a country goes through economic hardship. For example, Netflix has increased its international revenue tens of times since the company began to produce local international content.

Identifying Undervalued Stocks

An essential skill for investors who want to maximize their returns is to find undervalued stocks. As a prime example, Warren Buffet’s Berkshire Hathaway bought Apple shares in 2016 while the market sentiment was at its lowest because of the slowing sales of iPhones . Buffet knew that Apple is among the few companies that enjoy brand loyalty and that it had excellent potential in services, a positive aspect that almost no one was talking about. The results have been outstanding as Apple’s market value skyrocketed in the following years.

There are several essential financial measures that the investors use to find undervalued stocks. First, the P/E ratio is a highly common measure to compare a current share price with the per-share earnings. If a stock’s P/E ratio is lower than the industry average, it might be undervalued. Another circumstance where an apparent undervaluation is present is the economic downturn, which forces cyclical companies to the bottom of their business cycles. A similar effect can be observed with the use of the price-to-cash flow measure because the more volatile measures depend on numerous accounting choices while cash flow is harder to manipulate than earnings.

Second, the use of the P/B ratio is particularly important for capital-intensive industries. The P/B ratio is calculated by dividing the market value of a stock by its book value. If a stock is trading, for example, below 1, it means that it is trading below the company’s book value. Finally, the cash flow generated by a company can be used to determine its value. It is more difficult to manipulate than earnings because several hundreds of accounting standards are devoted to distinguishing between operating and financing cash flow. Offices can always be built for less or more money, but if a company cannot put sufficient employees in them to maintain operations, it will go bankrupt in a relatively short amount of time.

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