Investors who buy and sell on fundamentals - such as revenue, earnings, assets, liabilities and growth - believe that an investment’s performance should be based on the economics of the underlying asset are compelling. They tend to steer clear of technical indicators.

For example, according to a fundamental investor, a stock price should rise or fall based on the sales and profit trends of the underlying company; oil should trade based on its supply and demand trends; and a mutual fund should increase in value if the stocks, bonds or other investments held in its portfolio perform well.

"Fundamental" doesn't mean "no-brainer." Below is an overview of the important indicators that fundamental investors should know.

The Fundamentals of Fundamentals

Fundamental investors must first know what data to look for. The data for bonds is different from stocks.

Bond investing is relatively straightforward in that bonds have stated maturity dates and a coupon (aka bearer bond) payment that lets the investor earn income in return for buying the bond. An investor needs to compare the coupon payment to current market interest rates to form an opinion on whether the underlying business (for corporations) or local government (for municipal bonds) is strong enough and will have enough money to pay the bond off at maturity.

Fixed income investments come in many forms. Debt can be issued by corporations, governments, agencies and municipalities as well as mortgage-backed securities and even preferred shares. The last combines features of bonds and stocks.

Stock investing is more esoteric because there is no stated maturity date. Many stocks pay a dividend that brings in income, but stocks also trade according to how the underlying business performs over time. It is up to the investor to determine how to value a stock and whether the business trends are such that the investment can perform according to (or, ideally, ahead of) expectations. Below is a more detailed overview of these two factors.

The Valuation Consideration

There is a saying that every investment has its price, which is to say there is a buy price that will make the investment profitable, or at least make the odds of success as high as possible for an investor. For a bond, interest rates are the primary fundamental indicator that determines this. If a bond was purchased when it paid a coupon rate of 5% annually and market rates have increased to 7%, the bond will trade at a discount to newly issued bonds. Of course, the bond pays back at par value when it matures, which means the investor received his or her original investment back (assuming he or she did reasonable research to ensure the underlying business could pay back its debt). But the opportunity cost is that he or she could have waited and earned a 7% coupon because rates increased.

Returning to stocks, the price-to-earnings ratio, or P/E, is a great start toward determining whether a stock is over or undervalued. A P/E ratio represents the multiple of earnings paid for a stock. In 2014, S&P 500 P/E ratio is 15, which suggests buying into a company at this level is reasonable. Of course, there are factors to consider, such as what other good investments are out there, how profits are likely to grow over time, or whether the firm has a sustainable competitive advantage to protect its business over time.

Valuation isn’t as straightforward for other investments, but the general approach is the same. For a basket of securities such as a mutual fund or exchange-traded fund (ETF), the exercise to analyze an individual security must be done on each holding in the basket. Investing in commodities, art work or other physical assets is even more challenging because they don’t report annual sales or earnings, but there are stated market values from which to form the basis for what they are really worth.

Expectations Investing: Follow The Cash Flow

One of the primary beliefs of fundamental investors is that an investment is worth the sum of its future cash flows. A decision as to whether to invest requires estimating those cash flows, then using an interest rate to discount the total back to the present time to arrive at the current market value.

This kind of analysis is called discounted cash flow (DCF) analysis. It's part and parcel of the concept of intrinsic value, which is the theoretical value of a security, assuming its future cash flows can be known for certain. Predicting the future is of course impossible, but a fundamental investor does as much legwork as possible in these areas to try to predict what the future holds.

If the value calculated from a DCF analysis is above the current market price, then the security is undervalued. And vice versa - if the DCF value is below the current market price, the security is overvalued. For the investor, it is ideal if the DCF value differs materially from the market price. This is the margin of safety that Benjamin Graham, widely considered the father of value investing, explains in his book "The Intelligent Investor." With a wider margin of safety, there is enough cushion in case the estimates of future cash flows don’t turn out as planned.

Special Situations

When an investor becomes comfortable with the above fundamental factors, he or she can begin to look outside of more plain-vanilla investments for pockets where valuations can fluctuate more and discounts from intrinsic value could be found more easily. A spinoff, in which one company splits into two or jettisons a smaller business, is one such potentially lucrative space to look. The newly created spinoff is generally under-followed and may be sold off by investors who prefer to hold the parent company. In this case, the small business that is spun out is known as a "stub stock" and could be subject to near-term selling pressure. If the fundamental business is strong or improving, it could be undervalued. In 2004, bookseller Barnes & Noble (NYSE:BKS) spun out its retail game division, GameStop, to investors. GameStop has had its ups and downs, but has performed better than the parent company.

The Bottom Line

The techniques of fundamental investing underlie all types of investing. Basic indicators like P/E and DCF analysis form a good knowledge foundation, regardless of whether or not you intend to graduate to more sophisticated trading methods.

Related Articles
  1. Options & Futures

    How To Avoid Closing Options Below Intrinsic Value

    To get the best return possible on your options trading, it is important to understand how options work and the markets in which they trade.
  2. Active Trading

    Evaluate Stock Price With Reverse-Engineering DCF

    This is a more accurate method to use when trying to find a target price for a stock.
  3. Investing Basics

    DCF Valuation: The Stock Market Sanity Check

    Calculate whether the market is paying too much for a particular stock.
  4. Fundamental Analysis

    Intrinsic Value

    Learn more about this way of valuing a company or an asset based on an underlying perception of its true value.
  5. Investing Basics

    What Is The Intrinsic Value Of A Stock?

    Intrinsic value reduces the subjective perception of a stock's value by analyzing its fundamentals.
  6. Investing

    Discounted Cash Flow (DCF)

    Discover how investors can use this valuation method to determine the intrinsic value of a stock.
  7. Investing

    In Search of the Rate-Proof Portfolio

    After October’s better-than-expected employment report, a December Federal Reserve (Fed) liftoff is looking more likely than it was earlier this fall.
  8. Investing

    Time to Bring Active Back into a Portfolio?

    While stocks have rallied since the economic recovery in 2009, many active portfolio managers have struggled to deliver investor returns in excess.
  9. Investing

    Where the Price is Right for Dividends

    There are two broad schools of thought for equity income investing: The first pays the highest dividend yields and the second focuses on healthy yields.
  10. Economics

    Investing Opportunities as Central Banks Diverge

    After the Paris attacks investors are focusing on central bank policy and its potential for divergence: tightened by the Fed while the ECB pursues easing.
  1. What is the difference between a company's book value per share and its intrinsic ...

    Book value and intrinsic value are two ways to measure the value of a company. In simple terms, book value is based on the ... Read Full Answer >>
  2. What does low working capital say about a company's financial prospects?

    When a company has low working capital, it can mean one of two things. In most cases, low working capital means the business ... Read Full Answer >>
  3. Do nonprofit organizations have working capital?

    Nonprofit organizations continuously face debate over how much money they bring in that is kept in reserve. These financial ... Read Full Answer >>
  4. Can a company's working capital turnover ratio be negative?

    A company's working capital turnover ratio can be negative when a company's current liabilities exceed its current assets. ... Read Full Answer >>
  5. Does working capital measure liquidity?

    Working capital is a commonly used metric, not only for a company’s liquidity but also for its operational efficiency and ... Read Full Answer >>
  6. How do I read and analyze an income statement?

    The income statement, also known as the profit and loss (P&L) statement, is the financial statement that depicts the ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Take A Bath

    A slang term referring to the situation of an investor who has experienced a large loss from an investment or speculative ...
  2. Black Friday

    1. A day of stock market catastrophe. Originally, September 24, 1869, was deemed Black Friday. The crash was sparked by gold ...
  3. Turkey

    Slang for an investment that yields disappointing results or turns out worse than expected. Failed business deals, securities ...
  4. Barefoot Pilgrim

    A slang term for an unsophisticated investor who loses all of his or her wealth by trading equities in the stock market. ...
  5. Quick Ratio

    The quick ratio is an indicator of a company’s short-term liquidity. The quick ratio measures a company’s ability to meet ...
  6. Black Tuesday

    October 29, 1929, when the DJIA fell 12% - one of the largest one-day drops in stock market history. More than 16 million ...
Trading Center