Among the best approach to the stock market is being knowledgeable about companies. In order to achieve a greater level of understanding of the market, you have to know how to analyze it. There are generally two ways to analyze a stock’s performance: technical analysis and fundamental analysis. In this discussion, we’ll focus on the Fundamental analysis.
What is fundamental analysis?
You can think of fundamental analysis as the cornerstone of investing. It would even be fair to say you haven’t really experienced investing without doing some sort of fundamental analysis.
A huge part of fundamental analysis is diving deep into financial statements. That is also called quantitative analysis, involving analysis of revenue, expenses, assets, and liabilities. You look into these data in order to get a glimpse of the company’s future performance.
More than munching on numbers, you also need to look beyond financial statements. That’s the time when you have to learn qualitative analysis. Qualitative analysis is the breakdown of the intangible. These include the aspects of a company that is rather difficult to measure. And this is where we will shift our attention to. Read on!
Qualitative Factors of the Company
As we have mentioned, qualitative factors are the un-quantifiable aspects of the company. Rather than measuring them with numbers, we study them through other considerations.
There are many qualitative factors that you must consider. In this section, we’re going to focus on the qualitative factors specific to one company.
First off, it’s important to bear in mind that fundamental analysis attempts to find the intrinsic value of the company’s stock.
Before you look into a company’s financial statement or do any research, you must ask yourself an important question. And that is if you know and understand the company’s business model.
What exactly does this company, in which you want to invest, do? The company’s business model is the way the company makes money. In order to get a good overview of the company’s business model, check its website.
Some companies’ business models are easy to understand. They’re pretty straightforward. For instance, McDonald’s—they earn money by selling fast food to people. On the flip side, other companies’ business models aren’t that easy to understand.
Consider a restaurant brand that appears to be making money by selling food to people. You’d be surprised to find that that may not be true. Some restaurants make money from royalties and fees they get from franchises.
The rule of thumb is you should never invest in a company whose business model you don’t completely understand. Because you might get in trouble if you push for what you’re clueless about. That means you may lose money without ever knowing why or what hit you. In addition, investing in companies you don’t understand makes you uncomfortable and jittery.
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This is another fundamental factor to take seriously. Put simply, the long-term success of a company depends on its ability to gain competitive advantage. More importantly, the company must be able to keep that advantage.
Some examples of companies that have tremendous competitive advantage are Coca-Cola and Microsoft. The powerful competitive advantages that these sport create a moat around the business. In such cases, the companies can disarm or disable rivals from stealing the advantages. Ultimately, the company can bask in profit and growth.
Think of the company as an army that needs a captain who will lead them to triumph. In a way, that’s how a company functions. Therefore, it is very much imperative to consider the company’s management.
The management is responsible for steering the company towards financial stability and growth. For some, the management is the most important aspect of a company. They have very good reasons to think so.
Even the most powerful and influential kingdom would turn to ashes when an inefficient and corrupt leader heads it.
Now, the question is: how do you evaluate a company’s management?
As a humble investor, you don’t have the privilege to have a tete-a-tete with the company’s heads. You cannot just barge in and ask for the CEO and the Board of Directors to meet you.
You may try to check the publicly available information on the company’s website. But that’s just not enough to give you a good feel of the company’s management. It just won’t make the cut.
Also, a company would be prudent enough not to put any negative stuff about its management on its own website. So we don’t really count on that.
Instead, here are some ways to gain insight about the company’s management.
Typically every quarter, the chief executive officer and the chief financial officer host conference calls. If you’re lucky, other executives will also show up.
The first portion of the call is normally dedicated to reading financial results. But investors and participants are really jonesing for the question-and-answer portion of the call. This is the time when analysts can call in and ask the management direct questions.
This is your chance to get a feel of the management by listening carefully to the way they answer questions. Try to see if the officials answer directly, or avoid questions like politicians.
Management Discussion and Analysis
You can find the management discussion and analysis report at the beginning of the annual report.
Theoretically, the MD&A should be frank and honest, commenting on the company’s future outlook. In some cases the content of such report is worth your while. However, most of the time, it’s not.
In order to make the most of such report, compare it with those that appeared in the past. Check what the company is saying now and what it said in the past. You’ll be surprised at how much insight you will get by reading such reports. You can even go back five years in time and compare the company’s half-decade performance.
This is perhaps one of the most foolproof ways to gauge the management’s performance. It’s generally easy to find biographies of top executives online. Find the companies in which they have worked at in the past. And then check on those companies and determine how they performed.
Corporate governance refers to the policies within an organization. These policies denote the relationships and responsibilities between the management, directors, and shareholders.
The reason behind corporate governance is to guarantee that checks and balances are in place. This makes it difficult for anyone to commit anything unethical and illegal.
You can say that a company has good corporate governance if the company complies with all its governance policies.
Financial Information and Transparency
This aspect under corporate governance has something to do with the quality and timeliness of the company’s financial disclosure. Adequate transparency means that a company’s financial releases are trackable.
That means you can follow what the management is doing. This is important because it allows for a clear understanding of the company’s current financial status.
In fundamental analysis, this has something to do with the extent that the policies benefit stakeholder interests. Overall, since they are owners of the company, shareholders should have some access to the board of directors. That should be true especially when they have concerns or something to address.
One more important area of corporate governance is the amount of takeover defenses a company has. These include the measures that make it difficult for changes in the management to take place.
Structure of the Board of Directors
Representatives from the company and representatives from outside the company make up the Board of Directors. This combination tries to offer an independent assessment of management’s performance. Along with that, this structure makes sure that the interests of shareholders are attended to.
What you really have to look for when looking at the structure of the Board of Directors is independence. The Board of Directors has the task of protecting shareholders’ interests. Their job is to guarantee that the upper management of the company is also protecting such interests.
Moreover, the Board has the power to fire or hire the members of the Board on behalf of the shareholders. In many cases, a Board that has too many insiders in it will not be very efficient. The critical objectivity will be questionable. Usually, they will defend their actions as beneficial and good, not considering circumstances.
Those are just one part of fundamental analysis. In fact, we’re not done yet with qualitative factors. We still have to discuss about the industry. For now, all you have to remember is that fundamental analysis is a must if you are aiming for long-term investments. Learning technical analysis is not enough; fundamental analysis is necessary.
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