The beginning investor may find themselves at a loss for how to actually choose the stocks they are going to invest in. This being a highly profitable field of human activity, many different theories on how to do this have sprung up over the years. In this short guide, we will be taking a look at the most widely used system, fundamental analysis.
Fundamental analysis is considered to be the pillar of investing, and it is the foundation upon which many disparate investing strategies are based. For its wide application, the concept behind it is actually pretty simple. Fundamental analysis seeks to have a clear understanding of the most important parameters of a company’s business and finances, in order to get a sense for whether its share price will increase or decrease.
This involves answering certain questions about the quantitative and qualitative parameters related to a certain company. These questions include the company’s revenue growth, its profits, its level of competitiveness, as well as all outstanding debts. The final question to be answered, once all of these have been taken care of, is whether or not the company is a good investment.
As previously mentioned, fundamental analysis has a host of qualitative and quantitative tools at its disposal. Investors who only pay attention to one of those can often miss some important red flags, which leads to mistakes when investing. It is often the case that investors will focus on the quantitative data that is available, and neglect to take the time to interpret what that data means, which is the domain of qualitative analysis.
Nevertheless, investors must have access to a detailed account of a company’s business, and that is achieved by looking at a company’s financial statements. These statements contain the most important pieces of information about a company, such as its balance sheet, income statement, and cash flow statement.
All of these documents contain an often overwhelming amount of information, so a beginning investor would do well to focus on the most important ones first. Those metrics would include the net income, the profit margin, the debt-to-equity ratio, as well as the price-to-earnings ratio.
However, all of these metrics will mean very little to you if you don’t know the theory behind fundamental analysis.
In order to make sense of the vast array of financial information on a company, investors have to be aware of what exactly they are using it for. The goal of every fundamental analyst is to determine what is called the company’s intrinsic value. The intrinsic value is the objective value of a stock, in the view of the analyst, as opposed to the current market price of the stock, which may be overvalued or undervalued.
In order to find out what the intrinsic value of a company is, you need to look at another key metric, the company’s discounted cash flow. This is a term that sounds quite complicated, but let us break it down a bit.
Since the point of a company is to make profits, the value of a company, its discounted cash flow, is the sum of all of its future profits. The ‘discounted’ part of the equation comes in when you account for the time value of money, that is, the fact that a dollar you earn today is worth more to you than a dollar you will get a year from now.
This sort of reasoning makes sense when you consider the fundamental dynamic of any company. The value of a company is all of the profits you can skim off it when you’ve paid all your liabilities, including labor, debts, facilities, etc.
According to proponents of fundamental analysis, businesses are all about profits, and not about stock prices. Therefore, fundamental analysis can be viewed as more of a long-term strategy. However, there is another camp of investors who subscribe to the idea of technical analysis, which basically means paying attention to market trends in order to trade in stocks effectively, and make profits immediately, by analysing charts and graphs in order to find out what the market tendencies are.
The idea that underpins technical analysis is often referred to as ‘the greater fool theory’. Simply put, it means that it doesn’t really matter what a company’s intrinsic value is, since there will always be misinformed people on the marketplace who will be willing to pay more than the intrinsic value of a stock.
The person who buys an overpriced stock is the greater fool, so any errors made by technical analysts in relation to a stock’s intrinsic value is rendered irrelevant, since they managed to make money off it anyway, by selling it to the greater fool.
Deciding on one of these strategies is down to an investor’s personal style, as well as their goals. Neither has the definitive answer to the questions of investing, so each investor must make their own way.