We hear the word fundamentals on an almost-daily basis. Analysts, executives, and investors appear on CNBC daily to talk about the fundamentals of a stock. Fund managers are always talking about how this stock or that one 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. But what exactly are they? Read on to find out some of the fundamentals about stock fundamentals.
- Fundamental analysis involves looking at any data which 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 know when the stock price is wrong.
Fundamentals of Stock Fundamentals
In the broadest terms, fundamental analysis involves looking at any data which is expected to impact the price or perceived value of a stock. This is, of course, anything aside from the trading patterns of the stock itself, As the name implies, it means getting down to basics.
Fundamental analysis focuses on creating a portrait of a company, identifying the fundamental value of its shares, and buying or selling the stock based on that information. 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
- The soundness of capital management for the maximization of shareholder earnings and returns
Fundamental Investors: Stock and Bond Metrics
The Fundamental Approach
Fundamental analysts have a staid approach to analyzing stock performance. They look at a variety of factors that they believe influence a stock's performance. These include the industry as a whole, the competition, a company's management structure, its income and revenue, as well as its growth potential. 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.
Good Fundamentals Don't Equal 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 assessing 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 and make themselves money. 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 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.
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 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.
Fundamental Analysis vs. Technical Analysis
Fundamental analysis is much different from its cousin, technical analysis. Where fundamental analysis focuses on measuring a stock's intrinsic value, technical analysis concentrates solely on the trading and price history of a stock by looking at trading signals and other analytical tools to evaluate the strength or weakness of a stock.
Technical analysts believe that a stock's past performance—its price and trading activity—can help determine where it will go in the future. In essence, the theory of technical analysis is rooted in the fact that the movement in price is not random. Instead, it believes that patterns and trends are identifiable and repeat over time.
To demonstrate, let's go back to the analogy above. Technical analysts ignore the goods for sale. Instead, they 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, they will try to buy as many PCs as possible, betting that the growing demand will push PC prices higher.
The Bottom Line
There is much that investors 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 based on its "strong fundamentals."