How Does Fundamental Analysis of Stocks Work?
Fundamental analysis of stocks refers to the study of the intrinsic value of a stock conducted by examining the financial and business records of the company, as well as how the company is affected by economic and industry conditions. The aim of fundamental analysis is to predict the future performance of the stock based on the expected growth and earnings of the company.
One of the premises of fundamental analysis of stocks is that a company’s earning potential may not currently be reflected in its stock price, but that the stock of a well-performing company will eventually reflect that value.
General Areas Studied in Fundamental Analysis of Stocks
In overall terms, fundamental analysis encompasses three primary areas, starting from analysis of the economy in general, narrowing down to analysis of the relevant industry, and zeroing in on the analysis of the company itself.
It is important to assess the state of the economy, and how this influences the sector to which the company belongs. Conditions in the applicable sector, and often parallel sectors as well, are also highly relevant. Intermarket analysis can provide valuable information regarding the likely developments within a certain area of the market. Studying the relevant industry can help to understand the challenges that the company may be facing, and what its objectives should be.
Fundamental Analysis of the Company Itself
When focusing on the company under consideration, there are many factors which comprise effective fundamental analysis of stocks. These factors can broadly be classed as mathematical or financial, an area sometimes referred to a quantitative analysis, and structural, or qualitative analysis.
Quantitative analysis studies the financial reports from the company, including earnings reports, balance sheets, cash flow statements and financial projections. These documents provide the basis for assessing the ability of the company to generate growth and income for the investor. Warren Buffet’s criteria in this area include high Return on Equity (ROE), low-leverage and a high profit margin, and solid earnings projections.
Qualitative analysis considers the structure of the company, its management, and its positioning within the relevant industry. Understanding how the company operates is a key in this aspect of fundamental analysis. The business model is the first aspect to examine, and according to Warren Buffett, if you don’t understand this, don’t invest in the stock. It is impossible to make a sound prediction of a company’s future development without a solid grasp of how the company functions.
Studying the management style and structure is also essential to qualitative analysis, with the aim of ascertaining that the company and its future success are in good hands. A third factor is the competitive edge which a company needs to have in an industry. Market share, branding, and efficiency of operations are areas which can provide insight into the company’s ability to outperform its competitors.
Finally, it is important to research the company’s policies especially regarding areas like accountability to shareholders, and transparency of information.
Fundamental analysis of stocks involves thorough scrutiny of the performance and formation of the company in which stocks are offered. Both financial aspects, such as Return on Equity (ROE), leverage, profit margin, and earnings projections, and structural factors like business model, management, and market positioning are studied. This provides vital insight into the likelihood that the company will grow and thrive, which in turn will be reflected by increased stock prices, resulting in a profitable outcome for the investor.