Fundamental Analysis

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Why Use Fundamental Analysis

Fundamentalists look at the big picture and then zoom in to smaller details in an effort to determine if a stock is valued correctly at the current price. When the market price doesn't reflect the real value or potential value of a stock, its price is bound to go up in the future. Warren Buffet is a famous value investor who uses fundamental analysis to help him make sound investment choices. Even though people who use fundamental analysis tend to be buy-and-hold investors, many short-term traders do look at fundamental factors when screening for potential trades. They run a scanner for stocks that are fundamentally strong before using their technical tools for entry and exit points.

How to Use Fundamental Analysis in Stock Trading

Fundamental analysts first look at the overall state of the economy to determine whether the market is in a bull or bear phase. During a bear market, even the most valuable stock can become oversold and trade well below its intrinsic value. That's a buying opportunity for a shrewd value investor. From the state of the economy, the analyst then zooms in to the specific industry he's interested in. Companies in the same industry tend to move in correlation since they are often exposed to the same factors that are typical of the industry. When making comparisons, it's important not to compare stocks of different industry, since their fundamentals are very different depending on the industry they are in. Only by comparing stocks of the same industry can you gain insights about how a stock performs in relation to others of the same industry. The analyst determines the intrinsic value of a stock by looking at its financial statements over a long period of time. By analyzing its earnings, profit margins, return on equity, debt ratio, etc., he can have a better picture of how good or bad the company is performing and if the price the stock is trading at reflects that performance.

Quantitative and Qualitative Fundamental Analysis

There are many factors to consider when it comes to fundamental analysis. However, they can all be categorized into two groups:

Quantitative fundamentals

The data can be measured and presented in a numerical way. For example, the sales figures, revenues, debt ratio, quick ratio, etc. are all measurable in number. Investors can tell right away from looking at these numbers whether the company is performing better this year compared to last year or not.

Qualitative fundamentals

This data cannot be measured but is just as important. For example, the brand image value, competency of current management, or customer satisfaction ratings are things that are important to a company's growth but cannot be measured and presented in a numerical way.

How to Trade Using Fundamental Analysis

Most investors who rely on fundamental analysis shared that they have a strategy or trading system in place to give them an edge over the market. For example, a trader may find success trading a system in which he buys whenever P/E ratio is above its historical average or sells when EPS is expected to grow next quarter based on the consensus analyst estimates. Most real trading systems are more complicated than these two simple examples. However, the most important thing is to make sure you follow the system without deviation or changing rules on the fly.

Don't Get Emotionally Involved

Most traders fail to make money trading because they let their emotions take over when there's real money involved. Some have success trading a demo account but lose money when trading with real money because it's hard to think straight and follow the plan when a trade moves against you. Part of being a successful trader lies in the ability to control your emotions and not letting them dictate your trading. This can only be achieved with much practice and perseverance. Fundamental analysis is a powerful tool in an investor's arsenal. As you build your portfolio, sound fundamental judgment can help you spot undervalued stocks that will earn you significant returns in the future.

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Taking Advantage of Volatility

Public companies issue financial statements that show their earnings and expenses for a given period, usually three months or one year. These reports also include information about how the company is doing in terms of revenue and cash flow. Investors can use this information to find out if a stock they are looking at will go up or down by reading between the lines. You should never invest in a company without having analyzed its financial statements. Do not rely on someone else's analysis or guesses about the future performance of a stock you are considering buying because this is throwing your money away. However, the information contained in these reports can give you an edge over other investors and help to ensure that your investments perform well for you. To start, you need to understand the difference between earnings and cash flow when it comes to analyzing financial statements. Companies make earnings after they sell their products or services (revenue) minus all of the expenses associated with running a business for that time period. Cash flow is how much money flows into and out of business. This can be a better measure of how well a business is doing. It measures the actual money that comes into and out of the company from sales instead of measuring expenses against revenue to determine earnings. Investors should always analyze both numbers, but they usually focus on cash flow since this number tells them if a stock will go up or down.

The Cash Flow Statement

You have to read the cash flow statement in three sections. The first section shows how much money a company brought in, usually known as net revenue or sales. This is different from earnings because it does not include expenses when determining net revenue for use on this part of the cash flow statement. Next are operating activities, which show how much money a business had leftover after paying for its expenses. This number can be calculated in two ways: by subtracting the total of all operating expenses from net revenue or by adding up changes to cash and other assets or liabilities on this part of the statement. The third section is about investing activities, which shows what a business has done with the money it received from the sale of assets or what it spent to acquire new ones. This section can be broken down into two parts: investing in existing businesses (in other words, buying more stock) and investing in non-business activities like paying off debt or making acquisitions. Finally, a fourth section shows what a business has done with any cash left over after covering the three above categories.

The Income Statement

An income statement is very similar to a cash flow statement, but instead of showing net revenue minus expenses, it only includes earnings before interest and taxes (EBIT). This number does not have all of the same line items that are on a cash flow statement, but it leaves out non-cash expenses like depreciation and amortization. For example, if you bought $100 worth of goods from Walmart (WMT) using your debit card that has an interest rate of 20%, then paid off the balance at the end of the month with a credit card that charges 30% interest, you would have an income statement showing EBIT of $80 because your expenses are lower than the amount that went into your pocket. The other reason investors look at the income statement is to determine what a company's earnings per share (EPS) will be in order to see if they want to buy more shares or not. For example, if a company earned $20 million in the last quarter and has 100,000 shares outstanding, then its EPS is 20 cents. If you find that this number beats analysts' forecasts or is higher than it was from the same period last year, then you might want to buy more of this stock even though its price per share may not have changed.

Predicting Prices with Financial Statements

There are several different ways that investors can use financial statements to try and predict whether a stock price will go up or down. Unfortunately, there is no surefire formula, but there are some general guidelines that you should keep in mind when looking at the numbers. First, realize what kind of company it is so you know if its revenues are more likely to grow or shrink over time. For example, a software company's revenue is likely to increase year after year due to new products and services that its customers will want to buy. At the same time, a car manufacturer might not be able to sell as many cars when the economy slows down, so it would have less net income during those times. Second, pay attention to the company's debt to equity ratio because this number will tell you how much risk it has. If a company is not taking on any additional risks, then its debt-to-equity should be less than one. As a general rule of thumb, if the market value or book value (which can be found in the footnotes) of assets exceeds the company's liabilities, then it is probably in good shape. Finally, use other financial statements to try and figure out if a stock price will go up or down because investors are always looking for growth opportunities when they buy new stocks. For example, if you see that net revenue has grown by more than 25% over the last five years, then there is a good chance that it will continue growing at least by 20% or more each year. On the other hand, if you see that net revenue has only grown by about 15%, which is barely above inflation levels, then chances are it will not be able to grow much faster than this over time, and investors may shy away from buying it.

Final Thoughts

Investing in stocks is not just about buying a few shares here and there. There are several different types of investors, but no matter who you are or your strategy, it starts with analyzing financial statements and conduction a basic fundamental analysis to help determine whether a stock price will go up or down in the future. By understanding these basic guidelines for reading income statements, cash flow statements, and balance sheets, you will be well on your way to becoming a better investor.