Stock fundamentals are key metrics for a company, such as cash flow and return on assets (ROA). Analysts often perform fundamental analysis to analyze a stock by looking at its fundamentals. This involves examining any data which is expected to impact the price or perceived value of a stock.
Key Takeaways
- Fundamental analysis involves looking at any data that is expected to impact the price or perceived value of a stock.
- Some of the fundamentals of stocks include cash flow, return on assets, and conservative gearing.
- Performing fundamental analysis can be challenging because it requires digging through financial statements to determine when the stock price is incorrect.
How Stock Fundamentals Work
In the broadest terms, fundamental analysis involves looking at any data expected to impact the price or perceived value of a stock. This includes factors other than the trading patterns of the stock itself. As the name implies, it means getting down to basics.
Fundamental analysis focuses оn creating a portrait оf a company, identifying the fundamental value оf its shares, and buying оr selling the stock based оn that information. Some оf the indicators commonly used tо assess company fundamentals include:
- Cash flow
- Return on assets
- Conservative gearing
- History of profit retention for funding future growth
- The soundness of capital management for the maximization of shareholder earnings and returns
Fundamental analysts adopt a measured approach to analyzing stock performance. They look at various factors that influence a stock’s performance, including the industry, competition, management structure, income, revenue, and growth potential.
Example Of Stock Fundamentals
All of the data is public and readily available, generally through a company’s financial statements. The goal is to ultimately identify which stocks are priced correctly—and incorrectly—by the market.
To help you visualize it, let’s use the following analogy. Think of the stock market as a shopping mall, where stocks are the items for sale in the retail outlets. Their sights are set solely on the products in the mall. Shoppers are dismissed as an unreliable, emotional herd with no inkling of the real value of the goods for sale.
Fundamental analysts move slowly through the stores seeking the best deals. Once the crowd moves on from, say, the personal computers (PCs), they will take a closer look at the ones that were passed over.
Fundamental analysts may take a stab at determining the scrap value of the PC stripped down to its hard disk, memory cards, monitor, and keyboard. In the stock market, this is akin to calculating the book value, or liquidation price, of a company.
These analysts also take a very close look at the quality of the PC. Is it going to last or will it break down within a year? The fundamental analysts will pore over the specifications, scrutinize the manufacturer’s warranty, and consult consumer reports. Similarly, equity analysts check a company’s balance sheet for financial stability.
Then, the fundamental analysts may try to understand the performance of the PC in terms of, say, processing power, memory, or image resolution. These are like the forecast earnings and dividends identified from a company’s income statement.
Finally, the fundamental analysts will put together all the data and come up with the intrinsic value, or value independent of the current sale price. If the sale price is less than the calculated intrinsic value, the fundamentalists will buy PCs. If not, they will either sell the PCs they already own or wait for prices to fall before buying more.
Special Considerations
Performing fundamental analysis can be labor-intensive, but this is often the source of its appeal. By thoroughly reviewing a company’s financial statements and assessing its future prospects, investors can understand when the stock price is wrong.
Conscientious investors are able to spot market mistakes and profit from them. At the same time, buying companies based on intrinsic, long-term value protects investors from the dangers of daily market fluctuations.
However, even if fundamental analysis shows that a stock is undervalued, there is no guarantee it will trade at its intrinsic value anytime soon. Things are not that simple. In practice, share price behavior constantly calls into question stock holdings, and even the most independent-minded investor can begin to doubt the merits of fundamental analysis. There is no magic formula for calculating intrinsic value.
Important: Just because fundamental analysis shows that a stock is undervalued doesn’t guarantee it will trade at its intrinsic value in the near future.
When the stock market is booming, it is easy for investors to think they have a knack for picking winners. But when the market falls and the outlook is uncertain, investors cannot rely on luck. They need to truly understand what they are doing.
Fundamental Analysis Vs. Technical Analysis
Fundamental analysis іs quite different from its cousin, technical analysis.
While fundamental analysis focuses оn measuring a stock’s intrinsic value, technical analysis concentrates solely оn a stock’s trading and price history. Technical analysts use trading signals and other analytical tools tо evaluate a stock’s strength оr weakness.
Technical analysts believe that a stock’s past performance—its price and trading activity—can help predict its future movement. The theory behind technical analysis іs that price movement іs not random, and that patterns and trends are identifiable and repeat over time.
For example, technical analysts ignore the goods for sale іn the mall. Instead, they observe the crowd’s movements tо predict which goods might be іn demand. If a technical analyst sees shoppers crowding a PC store, they will try tо buy as many PCs as possible, betting that rising demand will push the prices higher.