Fundamental analysis of stocks is one of the most important styles of investing.
Many investors would say that you’re just gambling or speculating if you’re not doing fundamental analysis. And while there are a number of investing strategies, for the most part you can trace their style back to fundamental analysis.
There are a number of aspects you need to be comfortable with before you can even begin to put analysis into practice.
This includes learning about financial statements, SEC filings, valuation techniques and other various economic factors.
When fundamental analysis of stocks is used to determine the value of a security, it’s doing so in a way that focuses on the factors that affect a company’s practical financial performance.
Basically, if you can figure out if the company is actually doing well, then it’s a sign that the stock price should follow.
Four basic questions
Relying on these underlying performance measures of the company’s actual business helps investors ignore the price movements of the securities. Instead, they get to focus on the financial strength of the business.
There’s a few things that financial analysis should answer for you as an investor?
- Is the company actually profitable?
- Are revenues consistently increasing?
- Has the company positioned itself competitively for the future in the marketplace?
- Are debts able to be repaid or is the company in too much debt?
It must be noted that these questions just scratch the surface. There are a multitude of ways to think about and determine a company’s intrinsic strength for investing purposes.
Any kind of security can be fundamental analyzed, that includes stocks, bonds, derivatives and more. As long as you are basing your analysis off of fundamental economic values.
Some of the obvious points of reference you’re going to look at include things like profit and revenue.
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Simply put, if those are doing well the company you’re looking into is off to the right start. But it of course gets more complicated as the number of quantitative fundamentals are varied.
Anything with numeric values or can be easily measurable are worth looking into. Some more examples include:
- Financial ratios
- Important financial statement metrics (net profit, operating cash flow, etc)
- Return on equity (ROE)
- Return on assets (ROA)
- Future prospects
- Past performance
Now the intersection of qualitative metrics helps to tie all of this together for a grander picture of the fundamentals.
Neither method of analysis supersedes the other. Together they can help to determine if a stock is worth investing in or not.
Say for example that the stock is Amazon. While looking over the stock and applying fundamental analysis, the investor may review net revenue, annual dividend payouts, P/E ratio and then take into account other qualitative issues.
For example, things said by upper management on the direction of the company. Or taking into account the worldwide brand recognition and entering into promising markets.
All of this helps form the basis of fundamental analysis.
Some good ratios to always add into the mix would include: P/E ratio, ROE and dividend yield.
Once you have a general feel for the company being analyzed, it’s best to learn how to rummage through things such as the balance sheet, profits,, revenues and cash flow.
The best way to learn this is simply by doing. Eventually the numbers will start to make sense.
You’ll soon be able to gather all of this information into one single point. That is called the intrinsic value.
A fundamental analysis typically will not match a stock’s perceived current value on the market place.
The “true value” that you’re trying to reach — intrinsic value — can only be found through fundamental analysis.
For example, let’s suppose that a company’s stock was trading at $66. After a long bout of research into the company and fundamentals, it is found to be calculated at a true worth of $75.
Through your analysis and hard work, you’ve found that this stock is undervalued.
The goal is to buy a stock when it’s priced underneath its intrinsic value. Conversely, you can do the same if you believe that the stock is overvalued by selling short.
One of the major tenets of fundamental analysis is that the stock market should eventually correct itself to reflect the fundamentals.
How long this takes is anybody’s guess. It could be a number of quarters or go on for a decade.
Dealing with variables
Getting to that intrinsic value of a company and subsequently stock is the basis for this method.
But there are still a number of variables still in play even after all due diligence has been done. You’ll never be able to determine if a intrinsic value has taken into account all of the variables.
But it’s a lot better than throwing blind darts into the wind on the market. During the recession and financial crisis of 2008, there were many companies that continued to operate without major problems because of their fundamentals.
It was common to see companies with tight and sound business practices still paying their dividends and growing the business.
They of course were affected by overall market downtown, but as the stock market rose they were some of the first round of companies to flourish in the new, post-crisis era.
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It really comes down to the basics. If there is undue panic in the market or a strange flare up of some sort in your industry, these are less worrisome if you take a fundamentals approach.
Now if you’re concerned that the company is heading into a bad direction with a new owner or the profit margins look shaky, that might be a reason to sell or reconsider investing in a company.
While the world of investing can be perilous and outright random for even the most seasoned of financial analysts, there is a comfort in knowing that fundamentals act as a shining light on the path forward in your investing decision making.