Fundamental analysis investing strategies

Fundamental investing involves analysing the key financial ratios of a business to determine its financial health and to provide an estimate of the value of the business.

There is no one 'right' approach; however, it is important that you choose a strategy that fits your personality, the time you have available and your risk tolerance. Let’s take a look at four approaches that use fundamental analysis.

Value investing

The main principle of value investing is to buy quality businesses that are undervalued. A value investing strategy makes money when the price of the share rises to its intrinsic value and generally ignores day-to-day price volatility.

To arrive at an instrinsic value for a business means analysing a company's financials  and this process is entirely subjective.  Finding stocks that are undervalued can take a lot of research and share prices can often take a long time for their price to rise, so a long-term approach is essential for value investing.

Value investing isn't just about buying undervalued stocks. It is about buying quality undervalued stocks, so it's important to know what makes a stock good quality. Here are a few ratios you could consider:

  • Share price no more than two thirds of intrinsic value - pay less than an asset is worth
  • Low price earnings ratio  - pay less for more profit
  • Price earnings growth ratio less than one - another indicator of a low valuation
  • Low price to book ratio - an estimate of how much would be left over if the business was liquidated
  • Current asset ratio against current liability of greater than 2 to 1 - indicates the company can meet it's short-term obligations
  • High dividend yield  - useful to compare stocks in the same industry
  • High earnings growth  - for price to rise a business must be growing its earnings

Growth at a reasonable price (GARP)

The GARP approach is a combination of both value and growth investing. GARP investors look for companies that have:

  • A share price slightly less than their intrinsic value
  • Solid sustainable growth potential with a focus on realistic growth rates between 10 – 20%
  • Positive earnings for a number of years
  • Positive earnings forecasts for future years
  • High and increasing ROE
  • Preferably a low PE
  • Low price to book ratio or other similar criteria

Growth investing

This approach focuses on companies with future growth prospects and less emphasis on current price value. In fact, growth investors can buy companies that are trading at high PE ratio, in the belief that values will grow over time. Growth investors looks for companies that are more likely to reinvest their profits in acquisitions or expansion rather than use them to pay dividends to shareholders.

Here are some key ratios to consider for a successful growth investing strategy:

  • Strong historical earnings growth - at least 8% over the past 2 reporting periods.
  • Strong forward earnings growth - at least 10% for the next 1 to 2 years.
  • Profit margins - is the company efficiently controlling its costs  relative to revenues?
  • Return on equity (ROE) - a rising ROE indicates a company is increasing its ability to generate profits.
  • Price performance - how much has the stock price grown in the past one to 5 years? A rate of 15% per year implies that a stock has the potential to continue to grow.

Income investing

This strategy focuses on generating cash flow from investment holdings and either reinvesting the income to grow the portfolio or using it to fund spending needs in retirement. 

Here are some key considerations for a successful income investing strategy:

  • Dividend yield - is it above the market average? Is it artificially high? Does the company have a proven track record of increasing dividends?
  • Rising earnings per share - has the company generated positive earnings for at least 3 years?
  • Dividend payout ratio – is it consistently high? Is it sustainable?
  • Growth prospects - does the company have a high return on equity (ROE)?
  • Other qualitative factors -  to ensure that the company can continue to keep paying dividends