What is fundamental analysis? How understanding the underlying business helps you find great stocks of successful companies.
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There are, in broad strokes, two types of active investors. The first looks for price imbalances to make trades. A stock they can buy for $10 now and sell for $12 soon is a stock worth trading! The second type looks for bargains. If they can buy a stock for $10 and it's worth $12, that's a stock worth owning.
The distinction between trading and investing may seem small, but the difference in philosophy is vast. Trading seeks to profit from short-term imbalances in the market. Investing seeks to profit from the strength of the businesses underlying the stocks.
What is Fundamental Analysis?
Fundamental analysis is the process of examining all of the qualities of the business that can affect the value of a stock to predict its price. You may also have heard of technical analysis, which analyzes the behavior of the stock price to predict its price.
What goes on during fundamental analysis? Anything which measures how much a business earns, how effective its management invests earnings to provide future growth, and even the book value and intrinsic value of the business itself. Even free cash flow analysis is worthwhile on its own.
The question is "What's a share of this stock really worth?" and not "What will someone else pay for this stock?"
This analysis isn't limited to the performance of the underlying company. You should also pay attention to the economy as a whole and how the business fits into the economy. Are there economic factors that affect its sales and growth potential? For example, do steel tariffs make its products more expensive and less likely to be sold compared to competitor products?
Benefits of Fundamental Analysis
Fundamental analysis looks at data that's difficult to manipulate. While malicious companies can hide financial shenanigans in their balance sheets, good companies stay in business and poor companies go out of business. With a little bit of practice (and looking at the proper financial measurements, such as free cash or return on invested capital instead of EBITDA), you can rule out sketchy businesses and focus on finding good bargains.
Unlike technical analysis, you don't have to rely on big charts with fancy names. You can use the same financial measurements that accountants and analysts use. You're not trying to predict the future behavior of other investors based on historical trends someone has analyzed to the point of trying to find a pattern. You're banking on the assumption that good stocks will eventually be valued fairly by the market.
Limitations of Fundamental Analysis
If you buy a stock based on fundamental analysis, you're making two assumptions. First, that you're analyzed the stock effectively. Second, that the stock will reach or exceed its fair valuation in your time period. If good stocks can be undervalued by the market—and they are—they can stay undervalued for a long time.
A generous margin of safety can protect against you overlooking an important piece of financial data. Give yourself this cushion and you can be slightly wrong and still have plenty of room to profit from an undervalued stock.
Protecting against a lengthy undervaluing period is more difficult and requires more patience, because the antidote is time. If you're prepared to invest for decades, you can weather long periods of bear markets (or bear markets for your stocks). Remember, good companies are built to last. Over time they grow and get stronger and your patience will be rewarded.
Learning how to value stocks fairly takes time and effort, but you can go a long way by understanding free cash, the P/E ratio, and discounted cash flow analysis. No single financial measurement can tell you to buy a stock (though the lack of profit over a period of years can tell you not to buy a stock); the more you learn, the more you will be able to refine your analysis techniques.
You don't have to take Trendshare's word for it. For more detail, start with Tools of Fundamental Analysis.
Value investing is an exercise in patience, requiring time and research. Start now and gradually add more tools to your toolkit. Investing in your own education (to say nothing of taking control of your own financial destiny) will also reward you over time.