Financial analysis: how it works in practice

Find out how to conduct accurate financial analysis to help make informed decisions.

Financial analysis is an essential tool for any investor who wants to make informed decisions about their assets. It allows you to choose between different investment options, know what return you can expect, assess whether a particular asset is performing to its potential and even calculate whether it’s time to sell. There are different methods for doing this, each with different assumptions and applications, making this analysis particularly challenging. Find out about the different approaches to financial analysis and how to choose the one that suits you best.

What does financial analysis mean?

In the context of investing, financial analysis refers to the evaluation of an asset in order to make informed buying or selling decisions. This analysis is fundamental to maximising returns and minimising risk and can be applied to different types of assets such as equities, property, bonds and others. For example, equity analysis involves assessing a company’s financial statements and future projections, while property analysis focuses on the market value and potential yield of properties.

Financial analysis is of crucial importance because it provides the information needed to make informed decisions and to avoid making assumptions or using incomplete data. This analysis is important at various times: before investing, to monitor investments on an ongoing basis and to respond to market changes that may affect assets. In this way, you can identify investment opportunities and be more informed about the ideal time for buying or selling.

How important is financial analysis?

Financial analysis plays a key role in financial decision-making. Here are some reasons why:

• Assessing the financial health of a portfolio: financial analysis is the first step in identifying strengths and weaknesses in the composition of your portfolio.

• Helping you make informed decisions: this analysis can help you make investment decisions with greater confidence. This includes determining which assets to buy or sell, how to allocate resources and which strategies to implement.

• Protecting investments and assets: this analysis allows potential risks to be identified and quantified, so that measures can be taken to mitigate them.

• Monitoring performance: this step helps to identify areas for improvement and measure the success of the strategies implemented.

Financial analysis methods

There are different methods of financial analysis – some are based on the current performance of the asset, while others try to estimate its performance over time. Understanding these options is the first step to choosing the most appropriate method for your portfolio and making a correct valuation.

Fundamental analysis

Fundamental analysis is based on an assessment of the underlying economic and financial fundamentals of an asset or company, such as revenues, earnings, margins, balance sheet, management, etc. The aim is to determine the intrinsic value of an asset and whether it is under- or over-priced relative to its current market price. The central idea is that the market price of a stock will tend to move in the direction of its intrinsic value. 

How is the intrinsic value of an asset calculated? The most common method is the discounted cash flow (DCF) method.

This method is a financial valuation technique that calculates the value of an asset based on its projected future cash flows, discounted at a rate that reflects the cost of capital and the associated risk. The first step is to calculate future cash flows, taking into account expected revenues and deducting operating costs, working capital and investment costs. 

It is also necessary to calculate the terminal value (perpetuity), which represents the value of the asset at the end of the projection period. All of these cash flows are then discounted to the present using an appropriate discount rate, usually the weighted average cost of capital, to determine their present value. 

When to use it: Often used to value shares, it can also apply to property, bonds and other financial assets with predictable cash flows. It should be used whenever you want to make an investment based on an analysis that allows you to infer the potential of the assets, rather than just the value defined by the current capital market prices.

Comparative Analysis 

Comparative analysis, also known as valuation by multiples, is a method of valuing an asset by comparing it to other similar assets in the market. This method is based on the premise that similar assets should have similar values and facilitates the relative valuation of a company or asset in relation to its peers.

Comparative analysis uses ratios derived from a company's financial statements and market values. These are then compared with those of other companies in the same sector or with similar characteristics. When it comes to shares, one of the most commonly used ratios is the P/E (price to earnings) ratio, which is calculated by dividing the share price by the earnings per share. It shows how much investors are willing to pay for each unit of profit generated by the company. Another important ratio is price to sales, which is calculated by dividing the market capitalisation by the sales generated.

When to use it: Before investing, benchmarking can help determine whether the share price is reasonable in relation to the performance of similar companies. It can also be a good way to monitor the portfolio on an ongoing basis and identify when an asset may be over- or undervalued.

Technical Analysis

Technical analysis  is based on the study of historical price data, usually asset prices. The goal is to predict the likely direction in which a price will move in order to make profitable trades. 

Technical analysis is based on three basic principles: the first is that an asset is worth its price, i.e. it is neither undervalued nor overvalued. Secondly, technical analysis assumes that the past is cyclical, i.e. that the market tends to react in a similar way to past situations and stimuli. Finally, it assumes that prices follow trends – in the long-term, in the medium-term and even on the same day – but always in line with the general direction of the market.

When to use it: This approach is widely used for various types of assets, including equities, forex and commodities.

How to carry out a financial analysis of your portfolio

Carrying out a financial analysis of your portfolio is a multi-step process. However, it is essential for maximising the value of your assets.

1. Choose the valuation method

Start by choosing the valuation method that best suits the composition of your portfolio. If your portfolio is mainly in equities, fundamental analysis may be the most useful. However, if your portfolio is diversified, you should consider using a combination of methods.

2. Choose the indicators 

Identify the most relevant financial indicators for the assets in your portfolio. For example, for stocks, you might use ratios such as P/E (price/earnings). For bonds, analyse the interest rate and credit risk.

3. Collect and analyse the data 

Gather the financial data you need for your analysis. For example, if you are using fundamental analysis for stocks, assess the company’s revenues, profits, profit margins and balance sheet. If you’re using technical analysis, study price charts to identify patterns and trends. Accurate data is essential for reliable results in your analysis.

4. Compare with benchmarks

Compare the results of your analysis with market benchmarks. These can be sector averages or benchmark indices such as the Stoxx 600 or S&P 500 for equities. Comparing your investments with benchmarks helps you assess relative performance and identify potential areas for improvement.

5. Aggregate the results of different assets

To get an aggregate view of your portfolio, compare the performance of different asset types. Use a common measure, such as total return, which includes both capital appreciation and income (dividends, interest, rental income). This allows you to assess the relative performance of assets and understand the contribution of each asset to the overall performance of the portfolio.

6. Review and adjust portfolio composition

Based on the analysis, make adjustments to the composition of your portfolio. If you identify undervalued assets, you may consider increasing your position in those assets. If you find assets that are underperforming or risky, you may want to reduce or eliminate those positions.

7. Continuous monitoring

Financial portfolio analysis is not a one-off exercise. Monitor the performance of your investments on an ongoing basis and repeat the steps above on a regular basis. This will help ensure that your portfolio remains in line with your financial goals and adjusted to market conditions.

Banco Carregosa, expert advice on financial analyses

Financial analysis is essential for investors who want to make informed and strategic decisions. Understanding and applying these methods can be the key to achieving your financial goals. At Banco Carregosa, we have a specialised team ready to guide you through the complex financial environment of today’s market. Contact us to find out how we can help you carry out a financial analysis and optimise your investment strategy. Contact us.