Fundamental Analysis. Definition, Features, and More
Fundamental analysis is the process of analyzing a company's financial statements to determine whether it has sufficient earnings power and growth potential. The analyst must also consider other factors, such as management quality, competitive environment, industry trends, economic conditions, etc., in order to make an informed decision about the stock. Fundamental analysts are usually employed by brokerage firms or investment banks that specialize in securities trading. They may be paid on commission for their services.
The fundamental analysis approach was developed during the late 19th century when companies were required to file annual reports with the SEC. These filings included balance sheets, income statements, cash flow statements, and sometimes even footnotes detailing how much money each shareholder had received from dividends and share repurchases over time. Analysts would then use these documents to analyze the business model and predict future performance. This method became popular because it provided investors with information they could not get elsewhere at the time. However, this system did have some drawbacks: It only gave one side of the story, and there was no way to verify them. In addition, since most people didn't understand accounting principles well enough to evaluate the data themselves, many relied on brokers who often made misleading recommendations based on incomplete information. As a result, Wall Street began hiring accountants to do more thorough analyses.
By the early 20th century, the first "fundamental" analysts emerged. Their job was to take all the numbers reported in the annual report and combine them into a single document called a "financial statement." From here, they used various ratios to compare the current value of the firm against its historical values.
The modern-day fundamental investor uses similar methods but applies them to individual stocks rather than entire industries. For example, he might look at a particular company's P/E ratio compared to others in his portfolio. He will also examine the price history of the shares, looking for signs of weakness or strength. If the fundamentals seem favorable, he'll buy; if not, he won't.
Features of Fundamental analysis
1) A good fundamental analyst should know what he is doing. That means having knowledge of basic finance concepts like return on equity, net profit margin, book value per share, dividend yield, debt-to-equity ratio, and so forth.
2) An important part of fundamental analysis is understanding the difference between intrinsic value and market value. Intrinsic value refers to the amount shareholders actually pay for ownership of a company. Market value refers to the amount buyers are willing to pay for something. When you're buying a house, your mortgage payment doesn't include any interest payments. But when someone else buys your home, she pays both principal and interest every month. Similarly, when you own a piece of property, you don't receive rent checks from tenants. Instead, you collect those rents through your mortgage payment. The same thing happens when you invest in a stock. You aren't paying anything extra for that investment -- instead, you're receiving regular dividends as compensation for owning the company. So while the market may say that XYZ Company has an $80 million valuation, the true value of the company is closer to zero dollars.
3) Another key concept in fundamental analysis is risk tolerance. Some investors prefer high volatility, whereas other investors want low volatility. Risk tolerance can be measured by comparing two different types of investments: One type involves taking big risks, hoping for huge returns. The second option involves investing small amounts of capital in multiple ventures, where the chances of losing everything are lower. Investors with higher levels of risk tolerance tend to favor the former strategy, while those with less risk tolerance lean toward the latter.
4) Finally, fundamental analysis requires patience. It takes time to build up a large enough position in a security to make it worthwhile. In addition, some companies have very volatile earnings reports, making it difficult to predict future performance. This makes it hard to determine whether a given stock is undervalued or overpriced.
5) As always, there are exceptions to these rules. Sometimes, even though a company isn't cheap based on traditional measures, it still offers great potential because management is innovative or has unique products or services. Other times, a business may trade below its fair value due to poor accounting practices. Still other times, a company could offer tremendous growth prospects despite being expensive. However, most fundamentally sound businesses fall into one of three categories:
a) Those whose prices reflect their underlying values
b) Companies trading at bargain basement valuations
c) Undervalued companies that have strong competitive advantages
6) Fundamental analysis also helps identify which stocks will outperform during bull markets and bear markets. For example, if a particular industry experiences rapid technological change, then many new competitors enter the marketplace. These newcomers often cause price declines across all shares within the sector. On the flip side, however, they create opportunities for long-term winners who benefit from increased demand.
7) A final point about fundamentals: They should never drive your decision
making process alone. If you only use them to justify purchases, you'll end up missing out on good deals. At the same time, you shouldn't rely solely on them to sell off holdings. That's why I recommend using fundamentals alongside technical indicators like moving averages and relative strength ratios. Together, they help you avoid costly mistakes.
Now let me show you how this works in practice. Let's start with Apple. Currently, AAPL trades around $400 per share. Based on my calculations, this means that the company has a current P/E ratio of 17.8x. To put this number in perspective, consider that Google, another tech giant, currently sports a PE ratio of 18.1x. Both companies have similar revenue streams, but GOOGL generates more profit than does AAPL. So what gives? Well, as we've seen before, market cap matters too. And since both firms generate roughly the same amount of cash each year, the difference between their respective market caps reflects differences in valuation.
In fact, when compared to peers such as Microsoft, Amazon, Facebook, Netflix, Intel, and Hewlett Packard Enterprise, Apple looks downright inexpensive. But don't take my word for it. Check out the following chart, which compares the trailing 12 month P/Es of several technology giants against those of AAPL.
As you can see, while AAPL doesn't look particularly attractive by historical standards, it actually ranks among the cheapest of its peer group. Moreover, the firm boasts an impressive track record of consistent profitability and solid financials.
Frequently Asked Questions
Q: What exactly do fundamental analysts study?
A: Fundamentals refer to a company's economic health and balance sheet. In addition, investors pay attention to whether a stock is growing rapidly or shrinking. This information allows fundamental analysts to determine whether a company is undervalued or overpriced.
Q: How much weight should be given to fundamentals versus technical factors?
A: It depends entirely upon your risk tolerance level. Some people prefer to focus exclusively on one factor; others believe that no single indicator provides enough insight into future performance. Ultimately, though, you need to decide based on personal preference.
Q: Can I buy individual securities without doing any research at all?
A: No. You must first understand the risks associated with investing in equities. Only after gaining sufficient knowledge can you make informed decisions regarding buying individual securities.
Q: Is there anything else I should know about fundamental analysis?
A: Yes! Fundamental analysis isn't just limited to studying earnings reports. Instead, it also includes analyzing other important data points, including sales growth, return on equity, book value, debt-to-equity ratio, dividend yield, and so forth. These metrics are used to gauge a company's overall business prospects. They're especially useful if you want to identify potential takeover targets.
Q: Are fundamental analyses reliable?
A: Absolutely! The best way to ensure reliability is through thorough due diligence. That said, many investment professionals rely solely on fundamental studies because they provide valuable insights into a company's long term outlook.
The bottom line here is simple: If you invest in stocks, then you owe it to yourself to learn something new every day. As Warren Buffett once famously remarked, "It takes 20 years to build a reputation and five minutes to ruin it." By taking advantage of free resources like Morningstar, Yahoo Finance, Seeking Alpha, Investopedia, etc., you'll gain access to invaluable tools that will help you become a better investor. After all, who knows - maybe someday you'll even end up being worth millions...or billions.