Fundamental Analysis: A Guide to Mastering the Essentials

What is fundamental analysis?

Fundamental analysis is a method of research that studies financial information to forecast profits, supply and demand, industry strength, management ability, and other factors affecting a stock’s market value and growth potential.

It can be a valuable tool if used for long-term prospects, but not necessarily for tracking day-to-day stock price movement, market reaction to news or rumor, or temporary popularity of one industry group over another.

On the other hand, nonfundamental methods are known as technical analysis. Both use trends, approach uses historical information (dividend rates, profit or sales) to forecast financial results such as rates of growth, degree of expansion, and capital limitations.

The basis of fundamental analysis is accounting; where money and obligations come from and where they go. One of the advantages of studying the numbers is that it enables you to identify stocks that are currently undervalued by the market.

Fundamental tests provide a means for comparison. The result from those tests will guide in your decision to select one stock over another; and then leaving you to decide whether to buy, hold or sell.

The first assumption about fundamental analysis is that if you’ll use it, you need to remain objective. If you have a strong bias for or against a company or industry, the value of fundamental analysis is already compromised.

The second assumption is that you can analyze and research as well as anyone else. Vast amount of information is available through publication of financial statements, analysts’ reports, the financial press and the internet.

The majority of publicly traded companies report with integrity and can be depended on for reliable financial information. Doing some research is better than not doing research.

You’ll need to depend on information that may be weeks or months old by the time that it’s published... the critical information is the trend for the particular company. Mere availability of information does not make that information useful, you should seek reliability versus convenience.

Short-term thinking is not where profits are to be made. As Warren Buffett is quoted to have said, “Our favorite holding period is forever.”

Many people measure the market’s rise and fall by the Down Jones Industrial Average (DJIA), which includes 30 companies. The DJIA is believed to show a trend within the companies represented in the index. A more accurate measure of the market in terms of price movement may be the Dow Jones Composite Index which covers all stocks in the industrial, transportation and utility averages and reports them together. Alternatively, NASDAQ, which began tracking on February 5, 1971, reflects price movements of thousands of stocks, including those over-the-counter (OTC) market.

Many investors study only the fundamentals of the company selected, making the mistake of ignoring the trends of competitors and of industry-wide changes.

What are some useful indicators that a stock may be a good investment?

• Total sales is most common and best understood. If sales are rising, the company is growing.
• Net margin is the comparison between sales and profits, computed by dividing net profit by total sales. Make sure you use the correct figure. Three different versions of net profit can be found on the financial statement: operating profit, net profit (before taxes), and net profit (after taxes). The latter should be used for calculating net margin. A consistent net margin is viewed as a sign of a well-managed company.
• P/E ratio is considered to be a dependable means for making comparisons among a broad range of stocks. It’s calculated by dividing the stock’s current price per share by annual earnings per share of common stock. The P/E ratio shows the market’s current perception of a stock’s value at a particular moment. Higher P/E ratio stocks contain more risk, but also more growth potential.

How does this differ for bonds?

A bond investor doesn’t care whether a company earns a profit, dominates its industry, or acquires other companies. Only the company’s ability to repay its debt. In the bond market, credit rating matters. Bondholders have priority over common stockholders but not preferred stockholders. In the event of default, bond interest will be paid ahead of dividend. In the event of complete business failure, bond holders are repaid before shareholders receive any return.

Here are some key points in developing a program for analysis:

• Study the numbers and act on the information you develop.
• A company should be reviewed in comparison to its competitors in the same way a particular industry should be compared to others.
• Reexamine your portfolio regularly.
• Never stop researching.

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