How To Use Fundamental Analysis To Make An Investment Decision

You have been convinced that you should start investing in shares? Great! But there’s still the question on what to invest in that might leave you feeling overwhelmed. And it’s a question that has no clear one-size-fits-all answer online. But here’s how to use fundamental analysis to make an investment decision.

What is fundamental analysis

Fundamental analysis is a tool often used by investors who have a value based investment strategy.

The idea is to find an investment that has a market value (the current share price is the market value) lower than the “real value” given by the analysis. Then you would be able to buy this investment at a discount.

This is of course not an exact science and the results depend on assumptions you make along the way.

The main point of fundamental analysis is that you look at the company itself, the fundamentals of it and the environment that it operates in.

This in theory, and if done thoroughly, should give you an idea of what is a head for the company.

How to do fundamental analysis

In a fundamental analysis you start from the wide view and zoom in as you go. Here are the stages:

Economy

First of all, you need to look at the economy as a whole, as it will affect all companies within it.

What is happening in the global economy? The world is so interconnected now that nothing really functions in a vacuum anymore.

There are four stages in the cyclical pattern that economy keeps going through, these are expansion, peak, contraction and through.

Each stage has economic indicators and different businesses perform differently depending on where in the cycle economy currently is.

After you look at the global economy, you should look at the more local economy where the company operates.

For a New Zealand company this will be the New Zealand economy, for American company it would be the American economy.

While economies globally are interconnected, there are differences in the cycles of different localities.

Understanding the state of economy (and what might be next), is the first part of the analysis.

Industry

Next step is to look at the industry that the company you are looking at operates in.

How does the industry perform in the current economic conditions? How will it react to the next upcoming economic stage?

How does the company relate to its competitors, what is its market share? (Meaning, how big or small the company is in its field.) Do they have a unique selling point? What sets them apart?

Is there anything of interest going in the industry, like new regulations, or new innovations? How will these impact the company you’re looking at?

What is happening in the industry globally? How will that affect the industry locally?

Looking at the industry will further help you understand what kind of local environment the company operates in, and what might directly impact it.

Also, it will help you understand the competition and where the company you are looking at stands on the field. Is it the well established big player? Industry leader? Up and coming?

All important considerations when you are trying to predict where the company is going!

The company

The final step in the fundamental analysis is to have a deep dive into the company itself.

You might want to do a search if there are any headlines relating to the company and see what they are about.

Great resources for latest announcements and the sorts are the company website (if they are listed they should have pages on their website specifically for investors), the exchange they are listed on (like NZX for example) should have the main announcements available or pages like Finance Yahoo.

Next you need to have a look at the company’s financial statements (these should be available on their websites).

These statements should have a lot of information (beyond numbers), about the company’s mission, plans and current leadership for example.

The financial statements will give you a lot information. You can see how much debt the company has for example and of course, if they made a profit.

One of the key indicators of health is the cashflow statement.

Cashflow statement shows money coming in and money going out during the reporting period. Check the line that says “cashflow from operating activities”. This is the money coming in from normal business operations (as in, doing what the company is out there to do).

What this number should be is all relative. Is it rising, or declining? They give comparison years so you can see any trends. If there is a decline, what could be the reason? Wider economy or industry related? Or company related?

Key metrics to predict future earnings are often dividend yield, P/E ratio (price-to-earnings), EPS ratio (earnings-per-share) and dividend payout ratio. These can be calculated from financial statements, but they are also pretty readily available on sites like Finance Yahoo.

There are many other financial ratios you can use to evaluate company’s health, like different liquidity ratios, debt ratios, return-on-equity (ROE), the list goes on. If I went through all of them, this blog post would get very long, so I will get back to it in another post!

The main thing to understand though is that while some ratios have recommended values, what matters is how they compare to other companies in the industry, or how the current ratios compare to the company’s historical ratios.

This comparison can give you an idea of the company’s current financial state and help you make an educated guess as to where it will be headed. This should help you make an investment decision!

Calculating the “real” value

Remember how at the start I said that fundamental analysis will help you determine the “real” value of the company share and once you compare it to the market value (a.k.a current share price) you can make an investment decision?

Last step of this analysis is to make the calculation. The calculation involves assumptions about how much the dividends are going to increase in the future. Will it be steady? High growth first and then slow down?

The calculation is called the Dividend Discount Model (DDM) and the exact formula depends on the expected growth (3 options).

I will save the actual calculation to another post (if there is interest) but the idea behind this model is that the value of the share is based on the future dividends it will receive, discounted to its present value.

But even without the calculation, fundamental analysis should give you an idea of the company’s health, market position and help you decide whether the investment is of you or not.

The main advantage of the fundamental analysis approach is that it looks at things holistically. Looking at the global and local economy, then the industry, then the company itself in comparison to competition and in comparison to past performance as well.

This will give you a very good understanding of this particular investment option.

Disadvantages of fundamental analysis and DDM

Like with most theories and models, this one has its disadvantages as well. Here’s a couple:

• Since everything is taken to account, this can take a while to do. Not ideal if you are time-poor! (You will be able to outsource this though, for example Simply Wall St has share analysis available to you, their memberships range from free to two different paid options.)
• Overlooking important factors can easily change the conclusions
• Dividend Discount Model doesn’t work for companies that don’t pay dividends
• The performance of new and innovative companies can be hard to predict without comparison data or existing and established market

But overall I personally believe this can be very helpful when making investment decisions!

My personal experience using the analysis for investment decision

As you might be aware, I’m studying and my major is Financial Planning and Advice. One of my university courses had an assignment that required us to do a fundamental analysis on a company (this included making a buy/sell/hold recommendation).

We got to choose the company we’d analyse ourselves and I chose Z Energy.

(I’m sharing this in detail because Z Energy is no longer a listed company on its own after an acquisition last year, so my analysis no longer stands.)

This analysis was done in 2021 and was made very difficult by the fact that Z Energy had previously stopped their dividends and were quite impacted by Covid-19 and the NZ lockdowns.

In the end I determined that the poor performance was more about external, temporary factors and since there was talk about Z resuming dividend payments, I made a conservative hold recommendation.

At the time the shares were trading at about $1.14/share. My plan was to buy some to see how my analysis held, but in the end I forgot.

I went back to it later to find out that dividends had in fact been announced and the share price had moved from $1.14 to $1.34. I was a bit annoyed with myself for forgetting to buy some!

I ended up getting some then and there and ended up getting in on the dividends (their dividend yield was one of the higher ones in my portfolio).

In 2022 it was announced that they were getting acquired by an Australian company who would buy all the shares resulting in Z no longer being listed on its own.

In the end my shares were bought by this company for $1.74/share, so on top of the dividend they had experienced some capital growth as well.

This was a very interesting experience on fundamental analysis, which is why I do believe that it works, and when I’m less time-poor I will return to using it for my own portfolio.

Would you be interested to see an example of fundamental analysis done on a company? If yes, which company would you like me to analyse? Let me know in the comments!

(This would not be an investment advice, and I would omit my recommendation and possibly my own conclusion so you can do that for yourself without my influence.)