Fundamental Analysis Made Easy: A Step By Step Guide
I’m about to show you how to know if any stock, at any time, will make you money.
You see, if you want to invest in stocks, unless you opt for tracker funds and unit trusts, you need a method to help you pick them.
One way to do this, which has helped investing great Warren Buffett amass his fortune, is by using fundamental analysis.
But what is fundamental analysis?
What are the pros and cons of using it?
What are the most popular fundamental strategies?
And how can you use it to help you uncover profitable stocks?
Let’s take a closer look…
Fundamental Analysis Explained The Easy Way
Fundamental analysis is a way to evaluate a stock in a bid to work out what its intrinsic value is.
In other words, calculate what a share’s true value is.
You can achieve this by examining financial and economic factors, along with other measurements.
The subject of fundamental analysis is extremely broad and there are several different ways to do it.
A fundamental analyst will likely examine:
- Economic factors: This includes the current state of the economy and the industry a particular stock is in.
- Company-specific factors: This includes a company’s financial statements, management and prospects.
This will help a fundamental analyst to arrive at a value he or she thinks a stock is worth.
Then it’s a matter of comparing this to the current share price of a stock and deciding whether or not to buy.
In comparison to technical analysis, which uses charts and patterns to pick stocks, fundamental analysis involves a lot of investigation and number crunching.
Some of the information you need is easily available. Other information you’ll have to dig deep for or have to calculate yourself.
3 Reasons Why You Should Use Fundamental Analysis
Reason #1: Works Well For Long-Term Investors
If you’re looking to build a long-term portfolio, this form of analysis gives you a really good idea of what’s happening.
If you’re patient and willing to put in the groundwork, you could unearth stocks that go on to perform extremely well.
Reason #2: Uncover Undervalued Companies And Trends
It gives you the opportunity to find companies trading at a big discount to their intrinsic value, and market and sector trends.
This means, again if you have the patience, to buy these stocks and wait for the reward.
Reason #3: Provides You With Knowledge
By using fundamental analysis to examine potential investments, you get to grips with all aspects of a business.
You shouldn’t contemplate investing in a business that you don’t understand.
View investing in shares just like investing in any other business.
If a friend asked you to invest in his business and you didn’t understand how it worked, you wouldn’t. Apply this thinking to your investing too.
Knowledge means you’re in a better position to react to changes that could affect your investments over the long run.
3 Times When Not To Use Use Fundamental Analysis
When it comes to fundamental analysis, there are three specific times and reasons you shouldn’t consider using it.
Here they are:
Reason #1: You’re In It For The Short-Term
Fundamental analysis tends to work best for long-term investments.
This means, if you’re planning to jump in and out of stocks or trade, it may not be the best form of analysis to use.
Reason #2: It Takes A Lot of Time
Fundamental analysis is very time consuming.
If you don’t have the time to dedicate to it, it’s probably not for you.
And, you need to consider that all the time you invest into it doesn’t guarantee results.
Reason #3: Your Assumptions May Be Wrong
As a lot of the information you use with fundamental analysis comes from historic data, it may send you in the wrong direction.
This is due to the fact you use a company’s financial statements for a lot of the analysis.
Plus, a lot of the information you read may just imply certain things. So try to stay clear of reading material that isn’t factual.
The Most Popular Fundamental Analysis Strategies
This form of analysis is very broad, so different fundamental analysts use different ways to work out intrinsic values.
Top Down Or Bottom Up?
There are two broad ways to approach stock selection.
Top down involves looking at economic factors first, such as economic growth, interest rates and inflation.
From this, you then arrive at which stocks are likely to benefit from this.
Bottom up involves looking at specific stocks first.
This includes factors such as:
- Company management. Strong management is essential for a company to succeed over the long-term.
- The business itself. What does the company do? How are their competitors doing? And what are the future prospects for the business?
- The financials. This is the information you’ll find in a company’s financial statements. By using a variety of different ratios, you can derive what you believe the intrinsic value of a business is.
From the financials you can build a financial model to estimate what the future holds for the business.
In effect, bottom up is the opposite of a top down approach.
Benjamin Graham is behind this form of fundamental analysis.
This is the man Warren Buffett credits for his knowledge on the topic.
The premise behind value investing is to find companies with excellent fundamentals that are trading at a heavy discount to their intrinsic value.
You buy and you wait for the market to recognise this value.
This is definitely a form of investing for the patient. It could take many years for the share price to respond, if ever.
Buy And Hold
By using fundamental analysis, you uncover great businesses that look good for the long run.
This should reduce the chance of buying into a company which goes on to flop.
You buy these great businesses and hold on for the long-term.
Whilst many investors like to think the opinions of others don’t sway their decisions, chances are they do.
Contrarian investors pride themselves on using fundamental analysis to find unloved stocks have great futures ahead of them.
They buy and wait for the market to realise its wrong, which results in the share price rising in the future.
Using Fundamental Analysis With Technical Analysis
Some investors like to use both forms of analysis to find stocks to invest in.
This requires a lot of knowledge and skill as you need to be able to conduct both ways of analysis well.
Using The Economic Cycle
The economy tends to follow a cycle of boom and bust.
Some fundamental analysts use this to help them find great stocks that are only struggling due to the current economic stage.
These stocks are known as cyclical stocks.
For example, when the economy is booming, you’d expect construction stocks to do well due to demand.
If the economy tips into a recession, these stocks will likely suffer as the demand for their services ebbs away.
During these down periods, a fundamental analyst could use this as an opportunity to weigh up the different stocks within the construction sector and buy those with the best fundamentals.
When the economy recovers, the hope is the share price will bounce higher to reflect this.
How To Win With Fundamental Analysis
It’s Worth The Time
Just because you don’t know how to read a company’s financial statements now shouldn’t put you off fundamental analysis.
It will take you a bit of time to get to grips with everything, but it’s well within your reach.
Once you know how to read one financial statement, you can read any financial statement as they all follow the same format.
The investment of time to learn how to decipher them should pay off in the long run.
Fundamental analysis gives you the tools to cut through market noise and what market commentators are saying.
This gives you a great advantage over those who use other techniques to find stocks.
And it gives you a solid grounding to base your investment decisions on.
After all, no-one cares more about your money than you do.
A Margin Of Safety
Another essential technique you should employ with fundamental analysis is a margin of safety, especially if you’re going the value investing route.
A margin of safety is simply a way of leaving room for errors in your calculations to arrive at a stock’s intrinsic value.
For instance, let’s say your analysis leads you to believe that the intrinsic value of shares in Company ABC is R250 each.
The share is trading at R300, so looks attractive to buy based on your analysis.
To reflect that your value may, in fact, be too high, you factor in a margin of safety of 10% (R25).
This means you’d see the stock as an attractive buy up to R275.
The 9 Key Ratios You Need To Know To Perform Fundamental Analysis Like A Pro
If you want to put fundamental analysis to work, there are a number of key ratios you need to know how to use and interpret.
They will help you find the best stocks to put your cash into.
In fact, I've put together a 'Fundamental Cheat Sheet' with all 9 ratio's in it, and I want to give it you!
In it I detail the 9 must-have ratio's you can use to uncover the best stocks for your portfolio.
I'll tell you what they are, how to calculate them, and ultimately how to use them to pinpoint profitable stocks!
You just need to tell me where to send it.
The Importance of Paying The Right Price
The key behind fundamental analysis is paying the right price for a stock.
By conducting fundamental analysis you may uncover:
- Great undervalued businesses you can buy and hold onto for the long-term; and
- Great businesses to put on your watch list and buy when the price pulls back.
From fundamental analysis you’ll gain a much greater understanding of what you should pay for a stock.
Paying too much only erodes your future returns.
Be patient and wait for the right time to buy.
Over the long run, you’ll be glad you did.
Until then, here’s to tax free investing.
The Money Lab
PS: Don't forget to download your FREE Fundamental Cheat Sheet. In it I detail the 9 must-have ratio's you can use to uncover the best stocks for your portfolio! I'll tell you what they are, how to calculate them, and ultimately how to use them to pinpoint profitable stocks!