Fundamental analysis: from a line in the report to the price, and where that link breaks

Fundamental analysis answers the question of how much a business earns and how much the exchange asks for those earnings; it does not answer the question of when the price will arrive at the resulting valuation. For a trader this is the main limitation and, at the same time, the main benefit: fundamentals set the direction and the boundaries of risk, while the moment of entry has to be found by other means. A sensible combination therefore looks like this: the reason for the trade comes from the financial statements and from expectations, the timing and the level come from the market.

What exactly is being measured

Fundamental analysis works with a company's flows and stocks. The flows are revenue, operating profit, net profit and free cash flow. The stocks are assets, debt and equity. Setting them against each other produces the working quantities: profitability, the debt burden, and the share of profit that the business is able to hand to the shareholder without damaging its own development.

Next, a price is applied to the business. That is what a multiple is: the ratio of market value to some measure of performance. For SBER the price-to-earnings ratio — 3,92 — does not say "expensive" or "cheap"; it says only how many years of such earnings the current quote pays for, if conditions stay unchanged. Conditions are certain to change, and the analyst's entire job lies in the assumption about exactly how.

The source material sits in corporate disclosure. Quarterly and annual statements, the accompanying presentations and the decisions of the board of directors are found in the reports section, while the dates the market prepares for in advance are in the corporate events calendar. The nearest payouts on securities, if a dividend component is part of the idea:

A multiple is a ratio, not a verdict

A common mistake of the novice trader is to read a multiple as a judgement. A low price-to-earnings ratio can be a sign of undervaluation, and it can be a sign that the market does not believe those earnings are sustainable: a cyclical industry at its peak, a non-recurring revaluation of an asset in the report, an expected change in regulation. A high ratio can be the price paid for growth, and it can be the price paid for fashion.

Hence the working rule: a multiple makes sense only in comparison — with the security's own history, with comparable companies in the industry, with the risk-free alternative. That last comparison is especially harsh for the Russian market: when OFZ yields are high, a share is obliged to promise noticeably more than a government bond, otherwise the risk is not being paid for. A shift in the interest rate reprices the whole equity market at once, without distinguishing the quality of individual businesses.

Valuing the business and valuing expectations are different tasks

The price reflects not a fact but a consensus about the future. That is why a report that came out better than last year's can be accompanied by a fall in the quote: the market was expecting more. It is useful for a trader to keep these layers apart and to ask not "is the business good" but "what is already priced in and what is not".

The tool for that question is scenario analysis: several coherent versions of the future instead of a single forecast. Next to it stands sensitivity analysis, which shows which assumption really moves the valuation. It usually turns out that the model rests on a small number of assumptions — the discount rate, the pace of revenue growth, margins — and the rest is decoration. This is sobering: the precision of a calculation is never higher than the precision of its shakiest assumption.

How this turns into a trade

A sequence that survives contact with the market:

1. Select the idea on fundamental grounds: what is changing in the business or in its environment, and why the market has not yet priced it.
2. Name a testable condition — a report, a dividend decision, a regulatory event — and the date by which it will be known. No date, no trade: an open-ended idea turns into the open-ended holding of a loss.
3. Define the risk before entry: the level at which the hypothesis is considered refuted, and the position size at which that refutation is bearable.
4. Choose the moment — here technical analysis is appropriate, with its own area of responsibility and its own limits.
5. Review the idea when new data come out, not when the price changes. A fall in the quote is not, in itself, an argument either for or against.

What fundamental analysis does not do

It does not predict the quote over a horizon of days: in the short run the price is moved by capital flows, news and liquidity, not by the ratio of debt to profit. It copes poorly with businesses that have no clear reporting history. It is vulnerable to the quality of disclosure: when a company cuts back the amount of data it publishes, the valuation is built on guesswork, and it is more honest to admit this than to fill the gap with a confident figure.

A separate danger is analysis paralysis: deepening the research as a way of postponing the decision. The sign is simple — new information has stopped changing the conclusion, yet the work goes on.

The mirror-image subject is the limitations of the other approach, examined in the piece on the limits of technical analysis. Definitions of the terms that come up along the way are collected in the glossary; for a comparison with the debt alternative the bonds section will be useful, and for dividend ideas, the dividends section.