Fundamental analysis relies on numerous tools to give investors a picture of the financial health of a company and how the market values the stock, taking both quantitative and qualitative factors and data into consideration. Using this valuation, investors can make profitable investing choices.
Technical vs fundamental analysis
While technical analysis deals with understanding price movements on charts, fundamental analysis is about understanding the underlying asset that is changing hands at the quoted prices. And although fundamental analysis can be performed on just about any asset, we will be dealing with stocks only here.
Pricing assets and stocks
When you go into a store and buy a book for $9.99, someone else has done the pricing for you – your only choice is to buy the book at that price or walk out of the store and try to buy it somewhere else. There is no reasonable way to collect all the information needed to come up with the price of the book yourself. This simple truth actually applies to most goods bought and sold on open markets. But if you are an investor and want to buy stock, there is a history book that tells you all there is to know about the company in question: the Annual Report. And because a year is such a long time, and things happen fast, financial statements also come out every quarter, giving the investor an updated snapshot of the company's financial health.
What kind of questions does fundamental analysis answer?
A stock is a title certifying ownership of a fraction of a company. In effect, a buyer of a stock buys the corresponding fraction of the company , so it follows that the critical question in determining what price should be paid for that ownership is what the company as a whole is worth. This number is often referred to as the valuation of the company.
From a practical point of view, valuation depends on whether the books can be trusted (no cooking allowed!), whether the company is able to repay its debts or not; and whether its financial position is limiting its prospects compared to the competition. Other questions include whether the company's revenues are growing and if so, whether the co is making a profit or not. Furthermore, fundamentals can be either quantitative or qualitative, that is measurable (balance sheet, income statement, cash flow statement) or having to do with very relevant but not readily measureable properties, such as brand name recognition or entrepreneurship and management quality.
Because no company is an island, it has to be put in perspective: studying the relevant industry and overall market/economy conditions can be an important part of fundamental analysis as well.
But financial statements are not every investor's cup of tea: so instead of burying themselves deep within the books, investors and traders often rely on ratios, which can be found online on many financial web sites. For example, P/E is the price to earnings ratio: the higher the P/E, the richer the valuation. But just how rich is too rich?
The answer varies by industry or peer group and market conditions; but generally speaking, the lower the P/E the safer the investment (although too low a P/E can signal just the opposite, a distressed company). There are many other ratios, depicting a multitude of angles under which a corporation can be studied; for example the quick ratio shows how easy it would be for the company to immediately retire its current liabilities using only its quick assets. There are profitability ratios (e.g. ROI, ROE), liquidity ratios (e.g. operation cash flow, quick ratio), activity ratios (average collection period), debt ratios (e.g. debt to equity ratio) and market ratios (P/E, PEG, EV/Sales, etc.).
The holy grail: intrinsic value
However, the cornerstone of fundamental analysis is the axiomatic belief that there is a so-called intrinsic value of a company and its stock should be traded at or near that value (taking into consideration commissions and cost of carrying as well, according to some). When the stock price moves below the calculated intrinsic value, fundamental analysis suggests the stock is a buy – and vice versa. While basically valid, this model shouldn't be your only guide to investing. However, its basic premise has held true in most markets and for most assets for centuries: no matter what you buy or sell, if you have no idea of its value, you'll end up buying high and selling low, which is a one way ticket to losing everything.