In this article, I will show you the steps of fundamental analysis in equity research to analyze a stock. Fundamental analysis is how you turn an observation (this is an interesting company) into an actionable idea (what to do with the stock).
I used this exact process when I was an equity research analyst at BMO to create stock ideas for the world’s largest investors, like Citadel and Fidelity. Your portfolio and career can benefit when you use fundamental research skills to pick (or recommend) stocks with higher potential risk-adjusted returns.
Let’s dive in.
Step #1: Find out how the business makes money
The first question I always ask is, “How does the business make money?”
The research questions are:
- Who are its customers?
- How does it charge its fees?
- What are its main costs?
Once you find these answers, you understand the business drivers.
The one main thing that makes it money.
Examples:
- H&R Block: Tax filings
- Waste Management: Waste volume
- Google: Advertising on Google and YouTube
When you understand the drivers, you also get a sense of its growth and its risks.
For example, Paylocity makes money selling Payroll/HR software to small businesses1. It charges a fee based on the number of employees.
The risk is that businesses may reduce employees (in a recession) or switch software providers (if unsatisfied with the product). However, Payroll/HR software is essential to business operations (it is stable).
You can find these answers here:
In the company’s 10K or S1 filings, look at these sections.
- Business Overview
- Management Discussion and Analysis
- Risk Factors
💡 Tip: You can find them on EDGAR or the company’s investor relations section on its website.
Step #2: Identify the market trend
The next question is, “What is the addressable market?”
The research questions are:
- What is the market size?
- What drives its growth?
Once you have these answers, you understand the bigger picture. You can identify the trends that help the business grow.
Examples:
- MSCI: Index and ETF investing
- Nvidia: Artificial Intelligence
- Global-E Online: Cross-Border E-commerce
Once you identify the trend, you can judge how fast and far it will go.
For example, Paylocity operates in the human capital management (HCM) market. It’s estimated to be a $29 billion market that will grow slightly over 9% annually through 20302. Businesses use HCM software to automate tasks and save time and money.
Market growth means new sales for Paylocity (and other HCM providers). Paylocity has a low penetration of its addressable market (2%), which means plenty of room to grow.
You can find these answers here:
- Market research reports (search for industry reports)
- Investor presentations (also look in the transcript)
💡 Tip: Ask: “Why is X growing?” and the answer will reveal the trend.
Step #3: Evaluate the strategy
The question here is, “Why will this business win?”
The research questions are:
- Which businesses are winning?
- What makes them succeed?
Once you understand these answers, you can find a potential winner.
Examples:
- Moody’s Rating Service: Credit ratings are required by investors
- CoStar: Commercial real estate professionals need property data
For example, in the HCM space, businesses need more HR tools (video, learning, community) to retain employees and improve productivity. Paylocity’s strategy is to develop new product modules to win new sales in its target small business market.
There is evidence this is successful. Paylocity growing faster than its larger competitors (ADP / Paychex), which implies that it is growing its market share.
You can find clues here:
- Conference transcripts (including that of competitors)
- Comparing financial metrics (comparing sales, prices, etc.)
💡 Tip: Look for market share trends to see who is winning or losing.
Put It Together: Estimate the price
The question here is, “What do I do with the stock?”
The research questions are:
- What are the expected earnings?
- What is the expected valuation?
The answers help you estimate the risk and potential returns of the stock.
Here’s what to do:
Use a financial model to estimate the company’s earnings potential.
The model uses two inputs:
- Management’s targets for the company (also called guidance)
- Your assumptions (that reflect what you learned in steps 1-3)
In equity research, we often take management’s targets and then “back into” the implied earnings with our model. Then, we’ll use our judgment to tweak the assumptions to what makes sense to us.
For example, Paylocity has long-term financial targets of 20%+ revenue growth and 15-20% free cash flow growth3.
I’ll take these targets and use these assumptions:
- 16% growth in new clients
- 5% growth from pricing
- Flat margins (no margin expansion).
The model then gets to me to:
- ~20% growth in revenues
- ~15% growth in EPS
Or between $6-7 in earnings per share for Paylocity by 2025.
💡 Tip: You can find financial targets in investor presentations.
The earnings outlook is half of the battle. The second is valuation.
Here’s what to do:
Use the valuations of comparable (“comps”) companies or situations to determine the potential earnings multiple based on the characteristics.
The aim is to estimate the market value of the business. It’s the same process you do when you buy or rent an apartment or house (you look at the prices of similar places).
For example, Paylocity’s comps are HCM providers. Paylociy’s forward price to earnings multiple could be between 22x and 51x. Valuations in the sector tend to be higher when:
- Growth rates are faster
- Profit margins are higher
It is not a surprise that HCM companies that grow faster and have better profits tend to be more valuable.
💡 Tip: Use the price/earnings to growth (PEG) ratio to normalize multiples for different levels of growth.
I think Paylocity’s PEG (currently 0.9x) could remain stable and potentially rise to the industry median (1.3x) if its growth is stable.
Put together earnings and valuation, and you have a price (and what to do).
Now I have an idea of what to do:
Paylocity’s price could range between $130-$350, likely worth about $250 / share. I think it’s a reasonable price below $200 / share.
TLDR: Solid Fundamental Analysis Gets You Paid
Get the earnings outlook and valuation reasonably correct, and you will get paid by the market. Earnings outlooks and investor expectations (multiples) are changing all the time.
This is why stocks move around so much. This volatility creates the opportunity for you to use fundamental analysis to pick stocks and improve your potential risk-adjusted returns.
I hope this shows you how fun this can be!
Do you want to pick stocks for your portfolio (or career)?
Send me a message! I’d love to help.
Footnotes
- Paylocity’s 10K filing. https://investors.paylocity.com/static-files/1ed30b76-9009-4811-bb3c-95541bf75d63 ↩︎
- Human Capital Management Report (Fortune Business Insights). https://www.fortunebusinessinsights.com/industry-reports/human-capital-management-hcm-market-100240
↩︎ - Paylocity’s Investor Presentation. https://investors.paylocity.com/static-files/17a3a32a-db3a-4da9-9763-79d022931319 ↩︎
