There are, in broad strokes, two types of active investors. The first looks for imbalances to make trades. If they can buy a stock for $10 and sell it soon for $12, that's 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 when pondering the words alone, but the vast chasm of behavior is real. 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. This definition is often expressed in opposition to technical analysis, which measures the behavior of the stock price in an attempt to predict short term changes.
If you've read other pieces on Trendshare, you're probably thinking that free cash flow is one fundamental worth analyzing—and you're right! 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 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?"
Benefits of Fundamental Analysis
The primary benefit of this approach to choosing stocks is that it's based on data that's difficult to manipulate. Yes, malicious companies can hide financial shenanigans in their balance sheets, but over time 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'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
Yet that's an assumption, and assumptions have their weaknesses. If good stocks can be undervalued by the market—and they are—they can stay undervalued for a long time.
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.
You can reduce your risk in these two cases with appropriate caution. 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 years and decades and a lifetime, 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.
How to Learn Fundamental Analysis
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. There's no single financial measurement which tells 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 of individual stocks.
If value investing is an exercise in patience—and it is—then learning effective value investing is also an investment of time and research and effort. Start now and gradually add more tools to your toolkit. You'll find that investing in your own education (to say nothing of taking control of your own financial destiny) also rewards greatly over time.
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