Fundamental analysis: What is it? And how does it work?
In this article, we’re going to explore the basics of fundamental analysis, and take a look at how investors might use it to make informed investment decisions. Keep on reading for all of the details, or click on a link to head straight to a section…
what is fundamental analysis?
Fundamental analysis is a popular method of analysis used by active investors. The purpose of fundamental analysis is to determine the true, ‘intrinsic’ value of a stock.
Fundamental analysis works on the assumption that the stock market is inefficient. In other words, the market doesn’t always price stocks accurately. Because of this, the method allows investors to identify undervalued stocks and invest accordingly.
For example, if an investor believes a stock is undervalued, they may choose to buy it. On the flip-side, if a stock is considered overvalued an investor may choose to adopt a short position.
One of the most common ways to conduct fundamental analysis is to study company reports. That’s because company reports, or annual statements, often contain valuable information that can help investors study the health of a particular company. Let’s take a closer look…
what investors can look for in company reports
When conducting fundamental analysis, investors typically pay attention to the following figures found in company reports:
- Earnings per share: This measures a company’s profitability by dividing its net income by the number of outstanding shares.
- Price-to-earnings ratio: The P/E ratio measures the price of a company’s stock relative to its earnings per share.
- Price-to-book ratio: The P/B ratio measures the price of a company’s stock relative to its book value. Book value is simply the value of a company’s assets minus its liabilities.
- Dividend yield: This is the percentage of a company’s stock price paid out as dividends to shareholders.
- Debt-to-equity ratio: This is a firm’s level of debt relative to its equity.
After collating and analysing this data, investors may find themselves in a better position to calculate whether a firm is worth investing in.
How to undertake fundamental analysis
Before we outline some tips for conducting successful fundamental analysis it’s worth understanding that burying your head in company reports for hours on end won’t guarantee success.
Any form of investing carries risk, and there are investors out there who believe picking and choosing stocks simply isn’t worth the time. This is one of the main reasons why many investors prefer to passively invest in the stock market, rather than trying to pick and choose winners.
However, if you do believe you’ve the ability to beat the market and you’re willing to put in time to do the research, here are some tips to undertake fundamental analysis successfully.
1. Look into COMPANY REPORTS
As we’ve covered above, company reports can give an insight into a firm’s income, cash flow status, and overall financial health.
2. Consider management structures
An investor may wish to look into a firm’s management structure to assess its leadership style and previous track record.
3. Research market conditions
Industry and market conditions can have a significant impact on a company’s growth prospects. For example, if an investor feels a particular industry is set to expand, he or she may be inclined to invest in it. On the other hand, if an industry is seemingly on the slide, an investor may wish to stay clear.
4. Keep on top of current events
Keeping a close eye on news and events is often vital for investors looking to undertake fundamental analysis. For example, are there rumours a company is set to merge with a larger firm? Are regulatory changes on the horizon? Perhaps there’s news on economic developments impacting a particular industry. This sort of information can be extremely important when it comes to undertaking fundamental analysis.
what are the drawbacks?
If you wish undertake fundamental analysis it’s important to understand the following drawbacks.
1. Fundamental Analysis can be time-consuming
It almost goes without saying but having to conduct a thorough analysis of individual companies can take up a lot of time. This can be a big drawback for small investors in particular, as the payoff for spending hours reviewing reports, monitoring the news, and researching industries may not be worth the effort.
2. Beating the market is very difficult
Another potential drawback to consider is the fact that fundamental analysis relies on investors achieving above-average returns. The need to ‘beat the market’ is one of the biggest arguments against active investing in general. That’s because many investors hold the opinion that the market is always ‘one step ahead.’
3. It can be expensive
While we’ve covered the fact that fundamental analysis can take a lot of time (and time is money), active investing in general can often be far costlier than passively investing. For example, frequent trading, which is often necessary when picking individual stocks based on research, can lead to investors facing high share dealing fees. In contrast, investing in index funds or exchange-traded funds is typically a much cheaper way to invest.
Technical analysis vs Fundamental Analysis
When it comes to investing in the stock market, there are two main methods of analysis: technical analysis and fundamental analysis.
Technical analysis involves using charts and technical data to analyse the price of a stock and, hopefully, identify patterns and trends.
Because of this, technical analysis can be useful in identifying short-term trading opportunities. However, it’s often less useful for investors hoping for a long-term picture of a firm’s health and prospects for growth. For example, unlike fundamental analysis, technical analysis wouldn’t take into account financial statements, a company’s management team, or industry conditions.
Ultimately, whether to use technical analysis will depend on your investment goals and strategy. If you’re a short-term trader looking for quick gains, then technical analysis may be more appropriate. However, if you’ve a long-term mindset – which is often the most effective way to invest – then fundamental analysis is likely to be more effective.
To learn more about setting investment goals, take a look at our article which explains how to crate an investing strategy in 5 simple steps.
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Disclaimer: MoneyMagpie is not a licensed financial advisor. Information found here including opinions, commentary, suggestions or strategies are for informational, entertainment or educational purposes only. This isn’t financial advice. Anyone thinking of investing should conduct their own due diligence.