Going beyond betting
If you're like most investors, even the words fundamental analysis may turn you off a bit. Fundamental analysis sounds somewhat stuffy and academic. And it's true that fundamental analysis finds much of its roots in academia. But you might be surprised to find you probably are using some basic forms of fundamental analysis in your life, perhaps even in places you wouldn't expect.A great example of where a type of fundamental analysis is used is at the horse races. Before a race, you'll notice groups of bettors doing some serious work trying to pick the day's winning horses. Some may pour over the life histories of horses in the race, getting to know the jockeys and their techniques, and even studying how wet or dry the track is.
Although investing isn't exactly like horse racing, the analogy is a helpful way to understand fundamental analysis. For instance, some fundamental analysts will study a company like a bettor will study a horse. How successful has the company been recently, and is it healthy and well-cared for? Next, in fundamental analysis you might study a company's management like a better would consider the jockey. Is the management experienced, and has it competed against rivals before like the ones its facing now? Lastly, you must evaluate the broad economic climate, just like a bettor will consider the weather and condition of the track.
But here's where things get even trickier. It's not good enough to find the best company, or horse, to take the metaphor a little further. After all, if all the other bettors at the track did the same work and picked the same horse that you selected, you have a problem. The odds would be adjusted so that the payout on the favorite horse will fall. Bettors know that picking a favorite horse to win doesn't pay off much. And you're also taking a chance that the favorite will surprise almost everyone by losing and cost you money. Similarly, if you invest in a company that's widely considered to be a darling with other investors, your payoff is reduced.
Now that you see what fundamental analysis is, broadly speaking, consider how it can be applied to investing. Fundamental analysis is used to size up investments in several key ways:
- Analyzing the financial statements: Fundamental analysts pore over public documents companies provide to understand how the business is performing. Many fundamental analysts' starting point is digging into a company's financial statements to see how profitable a company is, how rapidly it is growing, what kind of financial health it's in, and whether it has the ability to withstand tough economic times.
- Getting an idea of how solid a company is: Many fundamental analysts are fixed-income investors. These investors have loaned money to companies, usually by buying bonds. Bond investors give money to a company in exchange for an agreed-upon payment each month, quarter, or year. Because bond investors get a fixed amount of pay, they don't care if a company is wildly successful. Bond investors, unlike stock investors, don't get a share of future earnings and growth. Bond investors just want to know the company is healthy enough so it can keep paying interest and return the money it borrowed.
- Understanding the value of a company: Stock investors use fundamental analysis to gauge whether a company's stock is a good deal or not. By studying financial statements, financial analysts determine whether a stock's price undervalues or overvalues the company.
- Going beyond the financials: Fundamental analysis goes beyond where accounting stops. Accountants' goal is to precisely measure business activity. Fundamental analysts are looking for much more: They want to understand how a business actually works and what it's worth. Using fundamental analysis, you will evaluate other factors that affect a company's prospects that go beyond what an accountant would care about. Common factors you might consider include sizing up a company against its rivals, determining how skilled a company's management team is in navigating through boom and bust times, and understanding the broad economic climate.
- Comparing a company's performance with its industry and competitors: A company's value, financial resources, or performance is measured relative to its peers. Fundamental analysis will show you how to not just size up the company you're interested in, but see how it measures up with the companies it is competing with.
Fundamental analysts take all the intelligence they gather to arrive at an investment decision and to take action. The most common question fundamental analysts ask themselves is whether a stock, at its current price, is cheap or expensive. The answer to that question will determine whether you choose to invest or not.
Understanding how fundamental analysis works
Fundamental analysts often dig well beyond a company's financial statements and try to unearth things. Sometimes fundamental analysts might spot a trend forming before a company's management acknowledges it. A fundamental analyst, for instance, might visit a retailer's stores and see how crowded they are to get an idea of what earnings might be in the future. Similarly, the fundamental analyst may try to get an idea of future demand by considering how busy a company's suppliers are.The goal of fundamental analysis is to measure how much a company is worth by using any shred of information possible.
The way you use fundamental analysis to understand what a company is worth gets down to the core essence of what a business is. With fundamental analysis, your goal is to monitor a company to see how it brings in money by selling goods and services to generate revenue. Next, you'll determine how much of revenue a company manages to keep after paying its expenses. What's left after paying all the bills is profit, or earnings.The fact that fundamental analysts take action on their research is what separates them from accountants. Fundamental analysts compare what they think a company is worth with what other investors think. If the stock is undervalued, the fundamental analyst will buy the stock. Accountants, on the other hand, have the job of recording sales and revenue, but not trying to profit off their findings.
Fundamental analysis isn't perfect. Fundamental analysis is rigorous and rooted in understanding the most basic elements of business. Even if you have no plans to be a fundamental analyst, knowing how fundamental analysis works can only boost your investment success.