How do I take qualitative factors into consideration when using fundamental analysis?

Fundamental analysis is the method of analyzing companies based on factors that affect their intrinsic value. It determines the underlying health and performance of a company by looking at key numbers and economic indicators. There are two sides to this method of analysis: the quantitative and the qualitative.

The quantitative side involves looking at factors that can be measured numerically, such as the company's assets, liabilities, cash flow, revenue and price-to-earnings ratio. The goal of fundamental analysis is to produce a quantitative value that investors can compare with a security's current price, to help determine whether the security is undervalued or overvalued.

The limitation of quantitative analysis, however, is that it does not capture the company's aspects or risks unmeasurable by a number — things like the value of an executive or the risks a company faces with legal issues. The analysis of these things is the other side of fundamental analysis: the qualitative side or non-number side.

Although relatively more difficult to analyze, the qualitative factors are an important part of a company. Since they are not measured by a number, they more represent either a negative or positive force affecting the company. But some of these qualitative factors will have more of an effect, and determining the extent of these effects is what is so challenging.

To start, identify a set of qualitative factors and then decide which of these factors add value to the company, and which of these factors decrease value. Then determine their relative importance. The qualities you analyze can be categorized as having a positive effect, negative effect or minimal effect.

The best way to incorporate qualitative analysis into your evaluation of a company is to do it once you have completed the quantitative analysis. The conclusions you come to on the qualitative side can put your quantitative analysis into better perspective. If, when looking at the company's numbers, you saw good reason to buy the company, but subsequently found many negative qualities, you may want to think twice about buying. Negative qualities might include potential litigation, poor research and development prospects or a board full of insiders. The conclusions of your qualitative analysis either reconfirms or raises questions about the findings from your quantitative analysis.

Fundamental analysis is not as simple as looking at numbers and computing ratios; it is also important to look at influences and qualities that do not have a number value.

(For further reading, see Putting Management Under the Microscope and Competitive Advantage Counts.)