We hear the word "fundamentals" on an almost-daily basis. On CNBC's "Squawk Box," for instance, company CEOs come out and proclaim that their companies have good fundamentals. Analysts and fund managers are always talking about how this or that stock has strong fundamentals. There are also some traders who, in turn, proclaim that fundamentals don't actually matter and investors should rely on a stock's "technical" merits instead. All this talk about fundamentals is confusing.

What are they all talking about?

The Fundamentals of Fundamentals
In the broadest terms, fundamental analysis involves looking at any data, besides the trading patterns of the stock itself, which can be expected to impact the price or perceived value of a stock. As the name implies, it means getting down to basics. Unlike its cousin, technical analysis, which focuses only on the trading and price history of a stock, fundamental analysis focuses on creating a portrait of a company, identifying the intrinsic, or fundamental, value of its shares and buying or selling the stock based on that information.

(For a more in-depth look at fundamental analysis, check out the Fundamental Analysis Tutorial.)

Some of the indicators commonly used to assess company fundamentals include:

  • cash flow
  • return on assets
  • conservative gearing
  • history of profit retention for funding future growth
  • soundness of capital management for the maximization of shareholder earnings and returns

Think of the stock market as a shopping mall: stocks are the items for sale in the retail outlets. Technical analysts will ignore the goods for sale. Instead, they will keep an eye on the crowds as a guide for what to buy. So, if a technical analyst notices shoppers congregating inside a computer shop, he or she will try to buy as many PCs as possible, betting that the growing demand will push PC prices higher.

The Fundamental Approach
Fundamental analysts have a more staid approach. 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. Our fundamental analysts move slowly through the stores seeking the best deals. Once the crowd moves on from the PCs, they will take a closer look at the ones that were passed over.

Fundamental analysts might 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.

(For more on this valuation method, see Digging Into Book Value.)

Fundamental analysts will 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 might 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.

(To learn more, read Find Investment Quality In The Income Statement.)

Finally, the fundamental analysts will put together all the data and come up with an 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.

Good Fundamentals Do Not Always Lead to Profits
Performing fundamental analysis can be a lot of hard work. But that is, arguably, the source of its appeal. By taking the trouble to dig into a company's financial statements and assess its future prospects, investors can learn enough to know when the stock price is wrong. These conscientious investors are able to spot the market's mistakes can make themselves money - a lot of it. At the same time, buying companies based on intrinsic, long-term value protects investors from the dangers of day-to-day market fluctuations.

However, the fact that fundamental analysis shows that a stock is undervalued does not guarantee that it will trade at its intrinsic value any time soon. Things are not so simple. In reality, real share price behavior relentlessly calls into question almost every stock holding, and even the most independently minded investor can start doubting the merits of fundamental analysis. There is no magic formula for figuring out intrinsic value.

When the stock market is booming, it is easy for investors to fool themselves into thinking they have a knack for picking winners. But when the market falls and the outlook is uncertain, investors cannot rely on luck. They actually need to know what they're doing.

Roll up Your Sleeves and Get Dirty
There is much that the investor can do to learn about fundamentals. Investors who roll up their sleeves and tackle the terminology, tools and techniques of fundamental analysis will enjoy greater confidence in using financial information and, at the same time, will probably become better stock pickers. At the very least, investors will have a better idea of what is meant when someone recommends a stock on strong fundamentals.

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