1. Macroeconomic Analysis
Types of fundamental analysis
Its importance is crucial when determining the basic lines of investment decisions, types of fundamental analysis . In particular, global investors with a presence in different international markets determine the distribution of their investments according to the results of the macroeconomic analysis of each country.
The relevant variables usually considered in the macroeconomic analysis are:
- GDP and its sectoral distribution
- The demand and its composition
- Foreign trade: imports and exports
- Balance of payments, exchange rate and foreign reserves
- Public deficit and its financing
- Monetary aggregates
- Wage costs
- Consumer Price Index
- Interest rates
The analysis of these variables must be carried out within the framework that represents the economic policy developed by the Government, since a large part of their future behaviour depends on the measures adopted by the economic authorities.
In this sense, the macroeconomic table prepared by the Ministry of Economy, which contains the objectives of the economic policy, and the Budget, which contains the financial accounts of the Public Sector, are two of the basic documents for such analysis.
Among the variables listed, the interest rate is perhaps the most important for the fundamental analysis. Its importance is explained by the very purpose of fundamental analysis as an instrument for investment decisions.
These decisions are made, according to financial theory, based on the comparison of alternative projects whose opportunity cost is directly related to interest rates.
In fact, the interest rates usually used are those corresponding to the State Debt (Treasury Bills and Government Bonds) which constitute the paradigm of risk-free investment returns and, therefore, the reference for the comparison of alternative investments.
In summary, the relative level and trend of the most significant interest rates in the economy are the most relevant variables in the fundamental macroeconomic analysis, which is used to determine the allocation of the funds to be invested among the different asset classes (equity, fixed income, real estate, etc.) and among the different countries.
2. Sectorial Analysis
Types of fundamental analysis
The sector analysis is a further link in the fundamental analysis and aims at studying the relevant factors specific to each sector.
The sectorial analysis involves the study of the following aspects:
- Regulation and legal aspects.
- Life cycles of the sector.
- Structure of the offer and exposure to foreign competition.
- Sensitivity to the evolution of the economy: cyclical, acyclical and counter-cyclical sectors.
- Exposure to price fluctuations.
- Short and medium term trends.
Sectorial analysis uses as its most common tool the reports of independent consultants, studies by official and private organizations and the periodicals issued by the various business associations and official bodies.
When the relative weight coincides with that of the Index, the situation of the sector is described as balanced or neutral.
When the relative weight in the portfolio or investment fund is lower than that of the Index, the sector is “underweight”.
This comparison is equally applicable when trying to determine the relative weight of each country in an international portfolio, for which macroeconomic analysis is used, and also to constitute a portfolio with specific values, for which it is necessary to go down to the analysis of companies.
This is the last and most detailed stage of the fundamental analysis. The final objective of this analysis is the determination of the intrinsic value of the company.
Once the value of the company is determined, it is compared with its price on the stock market and with that of other companies in the same sector, which must be comparable to the firm under analysis. This will determine if the company is cheap and therefore the purchase will be recommended or if it is expensive and the sale of the securities in the portfolio is recommended.
The specific analysis of a company involves both the study of financial and non-financial information.
The most useful sources of financial information are the following:
- Annual reports
They provide an overview of the company as well as its sectorial positioning. Including comparative financial statements between years that facilitate the analysis of the evolution of the main economic-financial variables of the companies.
They provide information on the criteria and methods of valuation applied in the company’s accounting, the important decisions taken, etc.
Quarterly financial reports
They are compulsorily submitted to the Stock Exchange Governing Companies and allow for the periodic monitoring of the relevant variables of the companies.
They are attached to the annual financial statements, and provide information on the criteria for the valuation and preparation of these financial statements and serve as an alert on hidden liabilities and significant risks.
They are essential for the analysis of groups of companies and holding companies, reflecting the situation of the companies with greater fidelity than the individual states.
The analysis of financial information consists, in short, of the analysis of the company’s financial statements; balance sheets, income statements and statements of origin and application of funds.
The analysis of the balance sheet emphasizes the financing structure of the company and the activity ratios. The balance sheet shows, on the one hand, the assets and rights owned by the company (balance sheet assets) and, on the other hand, the financing of these assets through own or external funds (balance sheet liabilities).
Financing structure comprises the level of leverage, i.e. the ratio between equity and debt and the net debt or liquidity position. The study of these factors and their evolution in previous years makes it possible to determine the future profitability of the company, the risk of bankruptcy or suspension of payments, future financing needs, etc.
The study of the two previous ratios allows us to analyse the financial structure of the company, whether the relationship between financing through own funds and external funds is adequate, etc.
Profit and loss accounts
The analysis of the income statement focuses on both its structure (margin analysis) and its evolution in recent years.
The analysis is based on a “cascade” arrangement of the income statement that allows the breakdown of the following concepts to be analysed:
- Cost of sales
- Personnel expenses
- Other operating expenses
- Tax rate
The study of the relevant concepts of the profit and loss accounts must allow for a sensitivity analysis to be carried out in the face of factors exogenous to the company which, in short, condition the evolution of its results.
Likewise, the analysis of the profit and loss account allows for the estimation of the company’s profitability threshold, that is, the level of sales above which the company makes a profit.
From the point of view of the stock market investor, the most important variable is the profit net of taxes, since it is the part of the profit on which he or she has expectations, either of receiving a dividend or of receiving an additional future return for reinvestment in the company’s typical activity.
For this reason it is necessary to analyse the current and expected tax rate, taking into account the various deductions applicable to the base and the corporate tax liability and the effects of applying accounting criteria that are not accepted for tax purposes.
States of origin and application of funds
They are prepared from the balance sheets corresponding to two consecutive years and include the financial movements of investment and financing recorded in the various accounts of the company in one year. Its analysis allows to estimate the future financing needs of the company, if its investment program is known, and therefore, to determine the need to make appeals to the stock market through capital increases or convertible bond issues.
It also allows to judge the dividend policy, the evolution of the debt and in general, the impact that the current and foreseeable financial structure of the company may have on future results.
The analysis of non-financial information incorporates, in addition to quantitative factors, others of a qualitative nature. The most relevant information not strictly financial in the analysis of a company is:
Market analysis involves the study of the relative position of the company in the market, the foreseeable evolution of demand, the structure of supply and the evolution of market shares, the technological situation, the pricing policy, the analysis of the distribution network, the importance of brands, and the exposure to foreign competition and the Single Market and its repercussions on possible alliances, company concentration, internationalisation, etc.
The study of market factors is essential for making projections of the income statement into the future.
It is crucial to know the future evolution of the company and involves the analysis of both the investment program of the year and the long-term plan.
Investments in the production process usually result in greater efficiency and a reduction in the cost of sales. Also, investments can be directed towards acquisitions of other companies in the sector or towards other sectors, that is, reflecting a process of diversification. In mature businesses, future profit growth can only come from the acquisition of companies in other sectors.
It is closely linked to investment policy, but also affects two essential aspects for the stock market investor: the use of the stock market and the dividend policy.
Financing decisions through own resources implies an appeal of funds to the market through capital increases, convertible bonds, warrants, etc. This appeal increases the number of shares in circulation and may cause a dilution of the profit corresponding to each share.
Financing by means of external resources involves the payment of interest that reduces the business profit as well as the return of capital borrowed at the time of its maturity.
The dividend policy is usually one more aspect of the financing policy. Growing companies, and therefore with high investments, try to retain as much profit as possible, so the dividend is usually small. Those companies whose business is mature, with low growth and investment needs, need to retain little profit and the dividend is usually high.
The analysis of the workforce in those labour-intensive sectors (services, construction, etc.) and the analysis of the commercial strategy in sectors linked to consumption or services, are other key aspects in order to be able to make a proper assessment of the company.
The analysis of critical factors, both financial and non-financial, that explain the evolution of a company’s results allows us to make estimates of its future behaviour and consequently determine its intrinsic value.