There are two main ways to analyze a stock, and decide if it is worthy enough to put your money in it. The first one is called fundamental analysis, where you study everything from the financial health of the company to the market conditions, the global and local economies, the performance of the competitors, etc. The second is called technical analysis, where you study the momentum and direction of the price of a particular stock or the market and use that to decide if the stock is a hot one to purchase or not. Though there are merits in both the approaches, fundamental analysis is usually associated with long term investing while technical analysis is often associated with speculation. In this post, I will cover the basics of fundamental analysis.
Fundamental analysis sees the business behind the stock instead of just the stock market and the traders. In other words, an expert fundamental investor is actually looking to buy a part/share of a business he considers to be fundamentally sound, instead of worrying about what its price will be in the next trading session. Fundamental analysts (or fundamentalists) believe that the health of the particular company and industry is the most important factor in the long term and that has little to do with the overall stock market movement. They believe that the market gives good companies its due over the long term.
“In the short run the market is a voting machine. In the long run it’s a weighing machine.” – Benjamin Graham, one of the pioneers of fundamental analysis. Graham wrote two of the bibles for fundamental investors – “Security Analysis” with Dodd in 1934 and “Intelligent Investor” in 1949. The ideas espoused in the book are still the core of the fundamental analysis used now.
Fundamental analysis is often associated with value investing and is practiced by famous investors such as Warren Buffett, Peter Lynch and John Bogle. Warren Buffett has made most of its wealth through fundamental investing and is the torch bearer of the segment.
There are 4 main components of fundamental analysis that are used by Buffett and other top fundamentalists.
Economic analysis – The most important element in a stock price in the short to medium term time frame is the economy. If the economy is bad, most of the stocks, regardless of the health of the company, is pushed into the drain. Good economy is the foundation of any stock and a fundamental practitioner pays special attention to the economic forecasts.
Economic factors such as interest rates can play a very significant role in the availability of capital to a company and thus their bottom lines. The numbers that are typically paid attention to includes the GDP (Gross Domestic Product) growth, unemployment rate, inflation rate, interest rates, housing starts, industrial growth, trade balance and the sovereign ratings of the government’s bonds.
Industry analysis – Industry analysis includes the prediction about the long term trends in the industry. For instance, you could look at the transport industry and conclude that the future of the industry is in electric vehicles and hybrids. If the conclusion is backed up with sufficient evidence you could use that to buy or sell an entire industry or pick particular stocks among them. Numbers such as the overall growth rate of the industry, the opportunities and threats, the health of the complementary and competing industries are all taken into account. Thus, when you look at the music industry, you should also pay attention to the disruption in the industry to be caused by companies such as Apple and Spotify Inc.
Company analysis – This is the real meat of fundamental analysis. This looks at the health of the company and its financial ratios. Every publicly traded company is mandated to release its financial statements to the market. This gives the analysts some insight into the company. Typical things that are looked in a company analysis are:
Earnings growth – Everybody loves a company that has an upward growing earnings trajectory.
Price to Earnings ratio (P/E) – this is the most basic indicator that says how much we are paying for a company per units of its profits.
Key executives of the company and how they are invested in the company. If the key executives are not competent enough or they are selling the company stocks in big number, there is a red herring.
Cash flow of the company – companies with solid cash flows are less risky during a financial crisis and are often run by management with a sound understanding of the business.
Dividends – Many fundamentalists consider dividends to be one of the pillars of a solid company and believe that a good, stable company ought to give back money to its investors.
Debt level of the company. If the company is loaded with too much debt, there are little chances that the company can survive in a liquidity or a credit crunch.
Price to Earnings by Growth (PEG) – this is a variation of the P/E ratio that takes into account of the fact that young and fast growing companies have a higher P/E ratio but need be necessarily considered as expensive.
Competitor analysis – On many occasions there might be no problem with the company’s financial statements, but can still be considered risky. When the competitors are growing faster than the company or are eating into its marketshare, it is very questionable that the company under question can be a good investment. A great example is that of Yahoo. This internet giant has good products, plenty of customers and is loved by its customers. But, since 2001, its competitors have started pushing it out of the pedestal in every segment. Thus, while Yahoo still has a sound balance sheet, its future as a viable, standalone business is under threat.
If used well, fundamental analysis can help you pick the right stock to hold for the long term. Fundamentalists abhor day trading and speculation, and are irritated by the fact that speculation is often confused with investing. Fundamental analysis takes plenty of patience and hard work, but if you put your effort there would be handsome rewards in the long term.
