Fundamental analysis and accounting information

Fundamental analysis is used to estimate a true value of an asset such as a company or a stock. Financial statements prepared by accountants and tested by auditors are used extensively in fundamental analysis.

1. Why accounting information is critical for fundamental analysis

Fundamental analysis is a study of relevant financial and non-financial information about an asset (e.g., a stock) to determine its fair or true value.  Usually, fundamental analysis makes heavy use of financial information derived from financial statements of a company.  Earnings, revenue and revenue growth, relationships between debt and equity, various other financial ratios, as well as inputs about market, industry, company conditions or assumptions (e.g., interest rates, industry trends, business model, management) are the starting points of fundamental analysis.

Results of fundamental analysis are expected to show a true or actual value of a company and its stock and how the stock value compares to its current market price.  If the stock value is lower than its market price then the stock is considered overvalued; if the stock value is higher than its market price then the stock is considered undervalued; and finally, if the stock value and its market value are similar, then the stock is fairly priced.  Performing fundamental analysis allows investors to make decisions as to whether they should sell, hold, or buy a particular stock.

It is important to note that even though fundamental analysis may provide useful information about stock valuations, a lot of investors don’t rely solely on fundamental analysis; instead, they supplement the results of fundamental analysis with other tools such as technical analysis (i.e., studies of stock price trends), etc.

Some of widely used financial data or financial ratios for fundamental analysis are as follows:

  • Earnings: this measure shows how much profit a company makes.  It is likely one of the most important measures as it shows how much money the company generates or, in the case of forward looking earnings estimates, how much money the company will generate.
  • Price to earnings ratio (P/E): this measure compares the current market price to the company’s earnings.
  • Projected earnings growth (PEG): this measure estimates a one-year earnings growth rate of a stock.
  • Price to sales ratio (P/S): this measure compares the current market price to the company’s revenues.
  • Price to book ratio (P/B): this measure compares the current market price to the company’s book value.
  • Return on equity ratio (ROO): this measure shows what return (e.g., profit) the company can generate on its equity.

A lot of data used for fundamental analysis comes from financial and accounting information.  The ratios noted above are derived from financial statements: balance sheet, income statement, cash flow statement, and equity statement.  These are the reports that accountants prepare; thus, the accounting profession provides valuable and critical information in order to perform fundamental analysis.

Sometimes it is hard for accountants to see the end result of their work as they spend a lot of time head down and crunching numbers.  At the end of the day, though, one of the products accountants create is a set of financial statements which are used by investors, financial analysts, etc. for fundamental analysis.  Another important player in the accuracy of financial statements is auditors.  They perform testing of financial and accounting information to ensure financial statements relied on by users of financial information don’t include any material misstatements.  So both auditors and accountants are on the “front lines” of generating financial information for its users.

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