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- Category: English
You know, for most people, stock investing means buying when the price is low with the intention of selling when the price increases.
Most people don’t even bother with research or any kind of analysis before investing their hard earned money.
I hope you aren’t as impulsive.
It is very difficult to succeed when you go into the battlefield with both your eyes closed.
Have you heard of fundamental analysis of stocks before?
It is one of the most important concepts when it comes to stock investing. Not a lot of amateurs know about the importance of fundamental analysis of shares, though.
So, in this article I’m going to explain the basics of fundamental analysis of stocks and how to use it to invest your money in the right companies.
Fundamental analysis is the foundation of solid investing. In fact, some would say you aren’t really investing if you aren’t performing financial analysis. However, the subject is so vast, it’s tough to know where to start. There are a plethora of investment strategies that are very different from each other, yet almost all use fundamental analysis.
Meaning of Fundamental Analysis:
Let me tell you what exactly fundamental analysis is.
It is the method of evaluating a security in an attempt to measure its intrinsic value, by examining related economic, financial and other qualitative and quantitative factors. It helps determine the underlying health of a company by examining the business’ core numbers: its income statements, its earnings releases, balance sheets and other indicators.
Sounds simple enough, right?
If you’re planning to buy a house somewhere, don’t you see what the locality is like? Or do you just move into a random house one fine day?
If you’re planning to do an MBA, don’t you research the colleges and available degrees to find out about market value, placements, fees, etc.? You don’t throw darts at a map to figure out where to go, do you?
Fundamental research is the equivalent of prior research when it comes to stocks.
I mean, before investing your money, shouldn’t you check to make sure the company has the potential for growth in the future?
That is common sense.
So, fundamental research of shares is not only important, it’s practically mandatory if you want to have any possibility of success.
The biggest part of fundamental analysis involves delving into financial statements. Also known as quantitative analysis, this involves looking at revenue, assets, expenses, liabilities and other financial aspects of a company. Fundamental analysts look at this information to gain an insight on the company’s future performance.
However, that is not all that fundamental analysis involves. There is more to just number crunching when it comes to analysing a company. This is where qualitative analysis comes in. Analysts break down the intangible, difficult to measure aspects of a company to build a complete wholesome picture of the company’s health.
Now that you know the basics of what fundamental analysis is, let’s get right down to it, shall we?
There are different methods of doing fundamental analysis. Different analysts prefer separate methods. However, to give you a better understanding, I’m going to tell you about the main steps involved in the process of fundamental analysis.
First and foremost in a top down approach would be an overall evaluation of the entire economy. The performance of the economy affects the performance of the companies. When the economy expands, most industry groups and companies benefit and grow. The opposite happens when the economy declines.
For instance, during recession, you wouldn’t expect the individual companies to be drowning in profits, would you?
Many economists also link economic expansion and contraction to the level of interest rates. Interest rates are seen as a leading indicator for the stock market as well.
Once a scenario for the overall economy has developed, an investor can break down the economy into the various industry groups.
Narrow Within The Group
Now comes step 2.
Once the industry group is chosen, an investor would need to narrow the list of companies before proceeding to a more detailed analysis.
The first task is to identify the current business and competitive environment within a group as well as future trends. Success depends on an edge, be it marketing, technology, market share or innovation. A comparative analysis of the competition within a sector will help identify the companies with a potential for success.
This is the main part.
With a shortlist of companies, an investor can analyse the resources and capabilities within each company to identify those companies that are capable of creating and maintaining a competitive advantage. The investor should look for companies with a sensible business plan, solid management and sound financials.
It’s obvious, isn’t it? Without a business plan, the company won’t even have a foundation to build on. Questions of feasibility, market demand and profits would come later.
What do you think the next most important thing to look for would be?
In order to execute a business plan, a company requires top notch management. Investors should look at management to assess their capabilities, strengths and weaknesses.
Even the best laid plans can go to waste if the management is incompetent. Alternatively, strong management can make for extraordinary success even if the odds are slim.
The final step to the analysis problem would be to take apart the financial statements and come up with a means of valuation. There are many different valuation techniques and a lot depends on the industry and the stage of the business cycle.
I’m not going to go into accounting details here, to cut a long story short.
A complete financial model can be built to forecast future revenues, expenses and profits. Alternatively, an investor can rely on the forecast of other analysts and apply various multiples to arrive at a valuation.
You’ll have to do this a couple of times and figure out what works best for you. Different people have different preferences.
After all the analysis is done, the final step would be to synthesize all the data and understanding into actual picks.
I know fundamental analysis of stocks sounds like a lengthy and complicated process, but it’s a lot simpler than it seems from the outside. And it is absolutely imperative in order to succeed in stock investing.
So, try it out yourself. That’s the only way you’ll understand. If you would like to add something or express your opinions, feel free to leave a comment. Happy trading/investing!