Fundamental research
Fundamental research (also called fundamental analysis) is a method of evaluating securities by examining the underlying business, financial statements, and economic factors to determine intrinsic value (Graham B., Dodd D. 1934)[1]. The stock price is $50. But what is the company actually worth? Fundamental analysts dig into balance sheets, income statements, and cash flows searching for answers. If intrinsic value exceeds market price—buy. If it falls short—sell or avoid. Simple concept. Execution requires years of practice.
Benjamin Graham formalized the approach in the 1930s, teaching it to generations of investors including Warren Buffett. The core premise: markets sometimes misprice securities, and diligent analysis can identify these errors. Not everyone agrees—efficient market advocates argue prices already reflect available information. But fundamental analysis remains the dominant approach among active investors worldwide.
Core philosophy
Fundamental analysis rests on several assumptions:
Intrinsic value exists. Companies have worth independent of current market price. This worth derives from future cash flows, asset values, and earnings power.
Markets can misprice. Prices sometimes diverge from intrinsic value—temporarily. Fear and greed drive prices too low or too high.
Analysis can identify mispricing. Careful study of business fundamentals reveals when prices deviate significantly from value[2].
Prices eventually converge. Mispricings correct over time. Patient investors can profit from this convergence.
The philosophy contrasts with technical analysis, which studies price patterns and trading volumes without reference to underlying business fundamentals.
Quantitative analysis
Financial statements provide the raw material:
Income statement
Revenue, expenses, and profits over a period. Key metrics:
- Revenue growth. Is the business expanding? Declining? Stable?
- Gross margin. Revenue minus cost of goods sold, divided by revenue. Measures pricing power and production efficiency.
- Operating margin. Operating income divided by revenue. Reveals operational efficiency.
- Net margin. Net income divided by revenue. What percentage of sales becomes profit?
Balance sheet
Assets, liabilities, and equity at a point in time. Key metrics:
- Debt-to-equity ratio. How much leverage? High debt increases risk.
- Current ratio. Current assets divided by current liabilities. Can the company pay short-term obligations?
- Book value per share. Equity divided by shares outstanding. A floor value in some analyses[3].
Cash flow statement
Sources and uses of cash. Key metrics:
- Operating cash flow. Cash generated from core operations. More reliable than accounting profits.
- Free cash flow. Operating cash flow minus capital expenditures. Available for dividends, buybacks, or reinvestment.
- Cash flow vs. earnings. Divergence between cash flow and reported earnings warrants investigation.
Valuation methods
Several approaches estimate intrinsic value:
Discounted cash flow (DCF). Project future free cash flows and discount them to present value. Theoretically elegant but requires forecasting years of cash flows—substantial estimation error.
Earnings multiples. Apply price-to-earnings ratios to earnings estimates. P/E of 15 times $5 earnings suggests $75 value. Simple but depends on appropriate multiple selection.
Asset-based valuation. Sum the value of underlying assets minus liabilities. Works best for asset-heavy businesses like real estate or natural resources[4].
Dividend discount model. Value equals discounted future dividends. Best for stable dividend-paying companies.
Comparable company analysis. Value relative to similar companies' multiples. If competitors trade at 12x earnings and your company at 8x, perhaps mispricing exists.
Qualitative analysis
Numbers don't tell the whole story:
Competitive advantage. Does the company have a "moat"—something protecting it from competition? Brand strength, patents, network effects, cost advantages.
Management quality. Are leaders competent and trustworthy? Track record, capital allocation history, insider ownership.
Industry dynamics. Growing industry or shrinking? Fragmented or consolidated? Regulated or free?
Business model sustainability. Can current profitability persist? What threats exist?[5]
Warren Buffett famously emphasizes qualitative factors—investing in businesses he understands with durable competitive advantages.
Top-down vs. bottom-up
Two approaches to organizing analysis:
Top-down. Start with macroeconomics. GDP growth, interest rates, inflation. Then narrow to promising industries. Finally, select best companies within attractive industries.
Bottom-up. Start with individual companies. Find attractive businesses regardless of industry or macro conditions. Sector and macro considerations come later.
Most analysts blend both. Pure bottom-up risks ignoring important macro headwinds. Pure top-down may miss company-specific opportunities[6].
Limitations
Fundamental analysis has weaknesses:
Information availability. Public filings provide substantial data but not everything. Management controls what's disclosed.
Forecasting difficulty. Valuation requires predicting future cash flows. Predictions are often wrong.
Timing uncertainty. Even correct analysis doesn't predict when mispricing will correct. Undervalued stocks can remain undervalued for years.
Market efficiency. If markets are efficient, fundamental analysis can't generate excess returns—prices already reflect all available information.
Behavioral biases. Analysts suffer the same cognitive biases as everyone else. Confirmation bias, anchoring, overconfidence[7].
Role in investment management
Different investors use fundamental analysis differently:
Value investors. Seek stocks trading below intrinsic value. Patient, contrarian, often buying unpopular companies.
Growth investors. Seek companies with above-average earnings growth potential. Willing to pay higher multiples for growth.
GARP (Growth at a Reasonable Price). Blend value and growth—seeking growth but not at any price.
Quantitative fundamental. Apply fundamental factors (value, quality, profitability) systematically across large universes. Combines fundamental concepts with quantitative methods.
Relationship to technical analysis
The distinction matters:
| Characteristic | Fundamental Analysis | Technical Analysis |
|---|---|---|
| Focus | Business fundamentals | Price and volume patterns |
| Time horizon | Long-term | Often short-term |
| Data sources | Financial statements, economic data | Price charts, trading data |
| Philosophy | Markets can misprice | Prices reflect all information |
| Question asked | "What is it worth?" | "Where is price going?" |
Some investors use both. Fundamental analysis identifies what to buy; technical analysis suggests when to buy[8].
| Fundamental research — recommended articles |
| Investment — Financial analysis — Decision making — Risk management |
References
- Graham B., Dodd D. (2008), Security Analysis, 6th Edition, McGraw-Hill.
- Damodaran A. (2012), Investment Valuation, 3rd Edition, Wiley.
- Penman S.H. (2013), Financial Statement Analysis and Security Valuation, 5th Edition, McGraw-Hill.
- CFA Institute (2020), Equity Asset Valuation, CFA Program Curriculum.
Footnotes
- ↑ Graham B., Dodd D. (2008), Security Analysis, Introduction
- ↑ Damodaran A. (2012), Investment Valuation, pp.1-25
- ↑ Penman S.H. (2013), Financial Statement Analysis, pp.45-78
- ↑ Damodaran A. (2012), Investment Valuation, pp.234-267
- ↑ CFA Institute (2020), Equity Asset Valuation, Chapter 4
- ↑ Penman S.H. (2013), Financial Statement Analysis, pp.312-345
- ↑ Damodaran A. (2012), Investment Valuation, pp.478-512
- ↑ CFA Institute (2020), Equity Asset Valuation, Chapter 7
Author: Sławomir Wawak