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You can use many different metrics to evaluate stocks and assets, but fundamental analysis is one of the most tried and tested methods. It might sound complex, but it can be both thorough and straightforward once you get the hang of it. After getting to grips with the basics, you’ll be able to make better decisions around buying and selling investments.
What is fundamental analysis?
This is a method used to evaluate how much a stock or asset is worth. The proper term for working out this “real” or “fair” price is known as calculating the “intrinsic value” of something. Fundamental analysis also allows you to review areas that could impact the future price. It involves a combination of reviewing the following elements:
- Financial statements, such as balance sheets, cash flow statements and annual reports.
- Microeconomic factors, such as the quality of the team managing the business.
- Industry trends, such as regulations, customer demand and level of competition.
- Wider events and macroeconomic influences, such as political risk, foreign currency and interest rates.
What are the different types of fundamental analysis?
There are 2 main types of fundamental analysis:
- Qualitative. This uses “soft” data and looks at subjective areas such as management decisions, brand value, sector cycles, relationship with employees and strength of research and development.
- Quantitative. This is much more number focused and looks at financial statements and balance sheets to calculate a fair value.
Why should I learn fundamental analysis?
Learning to use fundamental analysis will give you a direct advantage over the majority of retail investors.
Once you’re able to get your head around a few basic concepts, you’ll have a much better idea about whether you’re paying a fair price for an investment or if it’s undervalued. It will also help you make educated decisions about when to sell your shares.
How do I understand fundamental analysis?
The best way to understand fundamental analysis is to ease yourself in gradually. Once you have a basic idea of how it works and can grasp the major principles, it’s a good idea to break things down. Don’t try and overload yourself with information because it will feel overwhelming and might put you off.
A great place to start is by learning how to read financial statements like balance sheets. To begin with, you don’t need to know them inside out. Just pick one element, perhaps revenue or debt, to focus on first. Take a look at a few different financial statements to compare figures and get comfortable finding your way around them. Most look very similar. So, once you get the hang of it, you should be able to read most statements.
Where can you learn about fundamental analysis?
There are loads of free resources on the internet. You can find plenty of articles and videos breaking down the various elements of fundamental analysis. Or, if you prefer, there are some excellent books that will also show you real-world examples.
One of the best books is Benjamin Graham’s Intelligent Investor. Benjamin Graham was the mentor of a little-known investor called Warren Buffet. And, he’s often referred to as the godfather of value investing, which is based on fundamental analysis.
The most recent edition uses data from the 1970s with some modern commentary, but many of the tools are still relevant. It’s a bit of a nerdy deep dive into analysing stocks. There are also plenty of newer books explaining fundamental analysis for both beginners and more experienced investors.
How important is this analysis?
It can be a vital tool if you’re trying to make intelligent investing decisions like working out whether a stock has the potential to perform in the long run. Yet, as with any investment research method, it’s not a foolproof method that guarantees you’ll always pick the best stocks. However, you will definitely make smarter investing decisions when using fundamental analysis, reducing the chance of making costly mistakes.
How to use fundamental analysis
It can feel like there’s a lot to learn when you begin exploring how to use fundamental analysis. So, to make things a bit easier for you, here’s a simple step-by-step guide to follow:
- Understand the company. Before you get into the details, make sure you understand the underlying business. Find out how it makes money, its basic business model and who its customers and competitors are.
- Look at financial ratios. This includes things such as the P/E (price-earnings) ratio, EPS (earnings per share), debt ratio, PEG (price-earnings-growth) ratio, P/B (price-book) ratio and any others that are relevant. You can often find these online, so you don’t have to calculate them manually.
- Review the finances. Once you’re at the stage where you understand financial statements and can find your way around a balance sheet, you can use this to look under the hood of a stock.
- Check the debt. It’s useful to see how much money a company is making, but if it’s carrying lots of debt, this needs to be noted.
- Evaluate future prospects. Once you understand the company, think about its future prospects and the risks it may face in the wider economy. These risks include currency exchange costs, interest rates and having no pricing power to deal with inflation.
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Fundamental analysis vs technical analysis
Whereas technical analysis is based largely upon price and volume data for shares or other assets, fundamental analysis takes more of a holistic approach.
Fundamental analysis can be more useful for investors with a long-term strategy. Technical analysis is often better suited to traders. Ideally, it’s best to use a combination of both forms of analysis because each has its own usefulness.
What are the pros and cons of fundamental analysis?
Here’s a quick rundown of some of the major benefits and drawbacks of using fundamental analysis when assessing stocks and other assets.
Pros of fundamental analysis
- Helps investors and traders make more rational decisions.
- Less room for personal bias as conclusions are drawn from data.
- Allows investors to take a long-term view of assets.
- Provides a fairly well-rounded view of an investment.
Cons of fundamental analysis
- It can be time-consuming to research each stock or asset.
- Looking at so many areas of an investment can be complex.
- The results of your findings may take a long time to fully play out in the market.
- Unexpected or negative events can completely change the outlook for an investment.
How to use it to your advantage
This is a fairly thorough way to evaluate stocks and other investments. But, it won’t tell you everything or provide all the answers to your questions. Depending on your investing style and strategy, you may want to incorporate other research methods and forms of analysis before deciding whether to buy or sell an investment.
Fundamental analysis can take a little time to get the hang of. But, learning how to use it can be an extremely valuable skill. Learning a few basic principles and ideas will increase your odds of becoming a more successful long-term investor. However, it’s important to keep in mind that it’s not a perfect system. Like anything, it has its flaws.
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