What is fundamental analysis and why it’s used by investors

Fundamental analysis is a process of analyzing every aspects of a company’s operations in order to determine the value of a stock, known as intrinsic value of a share. This means, it will let you know what you are getting when you buy a stock.

By using fundamental analysis, you can find out whether a stock is cheap or expensive by comparing its current market price to the intrinsic value. If the company worth more than its stock price, as a investor you may bet on the stock.

Before buying a car, you probably weigh all short of factors to take a decision. The same approach applies when you buy stocks. There are number of tools available in fundamental analysis to let you know when and which stock to buy.

It’s a examination of the underlying forces that affects the company’s stock price such as economic conditions, business, industry, companies financial conditions and management performance. Most analysis will be focused on financial statements of the company.

At a company level, you need to analyse it’s financial data, management, business structure and competition. However, apart from these data, you are also required to focus on economic data, supply and demand of the product or services and industry.

The most fundamental thing a investor wants to know before investing is: how much money the company is making at present and how much it will make in future.

This means, you need to monitor how the company brings in money by selling its product or services to generate revenue. Next, you need to find out how much money the company is able to keep after paying all expenses. What is left over or kept after paying expenses is called net profit or earnings.

Company’s growing earnings and revenue can be a attractive investment if price isn’t too high.

Increase in company’s earnings leads to higher stock price. To monitor your investments, you need to keep tracking company’s earnings closely.

Before investing for a longer-term, it’s extremely important to understand the underlying business from various perspectives as stock prices of a fundamentally strong company appreciate over the period by creating wealth for its shareholders.

Fundamental analysis helps you to identify long-term wealth creating companies.

To start using fundamental analysis, you must first gather knowledge on following things;

You can get company’s income statements, balance sheet, cash flow, audit report and notes to accounts from annual and quarterly reports. Out of these, income statement, balance sheet and statement of cash flow are three key financial documents you can evaluate to know the financial performance of a company.

You also require to measure the assets (what the company own) and liabilities (what the company owes) to know how the company can invest its resources for future growth and when things get tough in the economy, can the company survive.

Industry data can be obtained from annual report of other companies working in the same industry.

One of the most important factor to determine financial strength of a company is it’s cash flow. It will show you how much cash is moving in and out of a company.

In addition to published information, you should also look at the management behind the company.

Financial tools used in fundamental analysis

Reported earnings is not the only thing you should look at. You should track the valuation of stock by using different fundamental analysis tools. Here is a list of financial ratios used in fundamental analysis:

In general, you take different numbers out of the income statement, balance sheet and statement of cash flows, and calculate different ratios in order to compare with each other. It will help you to determine whether the stock is cheap or expensive.

If as per your analysis fair value is not equal to the current market price, then stock is either overvalued or undervalued.

What is a undervalued or overvalued stock

If the current share price is less than the intrinsic value, then the stock is said to be undervalued. This means stock of the company is selling at a lower price in comparison to its actual true value arrived based on fundamental analysis.

In contrast, company’s stock is overvalued if the current share price is higher than the intrinsic value. This means investors are paying more for each amount of money the company earns.

Fundamental analyst will buy the stock when its undervalued.

Key elements of fundamental analysis

Some of the key elements fundamental analyst are followings:

  • Invest for a long-term not as a short-term trade.
  • Know the company’s intrinsic value (what a company is truly worth). Buying a stock well below what they are worth (intrinsic value), gives you a margin of safety to protect you from future trouble.
  • Analyse management
  • Understand the business. Know how a company is making money by analysing it’s financial statement.
  • Avoid companies with excessive debt as they may face difficulties in a trouble economy.
  • Don’t buy a stock just because another investor did.

Fundamental vs Technical analysis

Don’t get confused fundamental analysis with technical analysis. Both are different. Fundamental analysis helps your in a long term investment strategy. It won’t be helpful in short-term trading of a stock.

In contrast, technical analysis has nothing to do with financial performance of the company. It helps you to invest for a short duration or time the market by analysing trends in the stock price. This means based on market trend, you predict how a security will perform. This method is used by short term investors and traders.

It’s not necessary that stock investors should use fundamental analysis to read and analyse a company. Even lenders, mutual fund investors, management,board members and employees are using it to have a better understanding on the performance of a company.

As most of the part relates to financial analysis of the company, a background in accounting can help you to dig deeper into the performance of a company.

If you are afraid of investing in stock market or do not have time to analyse company’s financial conditions, then instead of investing directly into stock market, you can buy mutual funds that own stocks in number of companies. In this way, you will be safe if one or two company stumbles badly.

Fundamental analyst examine the business that is behind the stock to generate profit in the future that exceed the price they are paying. This means, they tend to buy stocks that they think are undervalued.

In addition to above financial parameters, you are also required to see few other aspects of a stock to know whether its an attractive investment or not. You can look for following aspects before taking a call:

  • Whether the company has financial resources to endure a downturn. This can be found by looking into liquidity position of the company.
  • Is there any improving trends in the company’s revenue and profit.
  • Can the management handle ups and downs of a business.
  • What is company’s real value. Does the bad news reflecting in current share price.