Fundamental analysis can be one tool to help you select stocks to buy, hold and sell depending on what it is you want the companies in your portfolio to deliver.
There are two elements to fundamental analysis: the number-crunching, which is about looking at the financial aspects of the company and seeing if factors such as revenue growth, debt and earnings stack up to form a picture for the future you are comfortable with.
The other part of fundamental analysis is more difficult to measure – intangible elements that also impact a company’s performance, such as its management and strategy.
Technical vs. fundamental analysis
Technical analysis involves employing software to look at charts that map price movements with the aim of using this to inform when you buy and sell.
Fundamental analysis and technical analysis are two basic ways people select stocks. Rather than looking at what the company does and whether they have free cash flow or earnings, and at the environment in which the company is operating, technical analysis is about focusing on patterns as they historically appear in charts.
In other words, in fundamental analysis you are concerned with a company’s value. In technical analysis, you’re really only interested in price movements in the market.
Who is fundamental analysis right for?
Fundamental analysis entails a lot of research and might require more time and effort than technical analysis. If you’re looking to invest for the long term, though, research is very important.
With fundamental analysis you’re really drilling down and focusing on whether you’re looking at a business you’re happy with. Technical analysis, on the other hand, tends to be used more by traders, who are likely to be more focused on a timeframe of days or even minutes, rather than investors who will be focused on what a stock will be delivering in years.
In other words, as an investor you will buy a stock because you believe it has the potential to increase in value, and you will need to employ fundamental analysis to tell you this. A trader using technical analysis, however, will be more concerned with capitalising on short term changes in price.
How do you get started with fundamental analysis?
As with most decisions you make in your investing journey, before beginning to determine whether you should buy, hold or sell a stock, you need to determine what it is you are wanting that stock to deliver.
Once you know what you’re trying to learn about a company, then you can start looking at company reports, which will contain information about both the financial position and performance of a company, in addition to giving you access to commentary from management that can also provide important insights.
Knowing what to look for can be tricky, which is why some investors will choose to use various financial ratios to help them drill down and make sense of the results. Financial ratios can help you interpret results and make comparisons to previous years, other companies and the industry sector.
There’s a number of financial ratios that are commonly used, depending on what you want to focus on. You may want to see, for example, consistent earnings growth, or you may be interested in growing dividends or, if you’re more conservative, you might want to see low debt.
It’s worth noting, however, that these ratios aren’t simply used in isolation. It’s important not to forget the qualitative aspect of the analysis too, which is about assessing how well you understand the business, and how comfortable you are with the direction it is taking in its pursuit of added value.
“Unfortunately, balance sheet and ratio analysis is probably the most daunting part of fundamental analysis for non-professional investors”, the ASX says in its course notes on the topic.
You’re unlikely to have to do much number crunching yourself as professional stock brokers and trading platforms will give members access to this information. It can, however, get complex tying all these factors together as you complete your research. This is where something like an investment journal can help you keep track of your logic as you work towards an investment decision.
What are the limitations of fundamental analysis?
As with most things, fundamental analysis is not without its limitations, and it’s important to go into this with your eyes open.
One of the big potential limitations comes down to how well you understand the business and therefore how well prepared you are to understand the implications of changes to the value of a company.
One of the downsides of fundamental analysis is that you can miss out on big moves in shares because you might not be quick enough to assess what a company announcement means in the context of the model you’re using.
Markets move on supply and demand in their own way, and that realistically might not have anything to do with the fundamentals of a company. So working out what you determine to be its value as things are changing and emotions start to kick in isn’t easy.
If you’re thinking long-term as an investor, ultimately the important thing is to understand when you need to act without simply reacting.