What’s Fundamental Analysis

Fundamental analysis is a technique of choosing stocks by assessing fundamental measurements like earnings per share, revenue growth, cash on the balance sheet, increasing debt, etc, to evaluate what you imagine a stock should be trading at down the road. By comparing the value you suspect the stock ought to be worth, also known as intrinsic value, you can make a decision on if the stock is at an excellent price to buy today depending on the current price it is actually trading at. Where it could get complicated is in how we determine what a companies intrinsic value is.

What Fundamental Analysis Isn’t

Fundamental analysis isn’t a great forecaster of short-term price movements. Generally, fundamental investors are intermediate to long term investors because they need time for their thesis to play out. Many things can happen in the markets from a everyday perspective, but over the longer term, stocks with positive fundamentals have a tendency to trend higher in price and reap benefits for longer term holders.

Advantages to Fundamental Analysis

The principle advantage to using fundamental analysis is that you can have real confidence behind the stocks you hold. By learning and analyzing a stocks long term story, you are able to better understand the vision of where the company may potentially be in the future. If you find great fundamentals like increasing earnings per share and revenue growth, you are more likely to keep the stock for the big 50 to 100% gains without having to be shaken out by small 5-10% pullbacks that come along the way. Another advantage is when you’re employing a “value” approach, fundamental investors are usually the first to purchase extremely beaten down stocks that may net big percentage gains over the subsequent years. Provided you can find stocks that are trading at deep discounts, aka have good “value”, you can take advantage of incredible stock returns before a stock even comes on the radar of a technical analyst.

Disadvantage of Fundamental Analysis

Fundamental analysis can be quite risky if you do not use proper risk management. Calculating a companies intrinsic value involves some type of prediction or anticipation of what an organization will earn down the road. One cloud that hangs over all forecasts of future estimates is the economy. When there is a tough economy, like there was in 2008, future earnings estimates of almost every company can come down and therefore you will have to adjust your expectations of a stocks future price. If you don’t manage your risk, or have a spot where you cut your losses, you may wind up riding stocks all the way down to $0.00 as numerous did with banking stocks in 2008. It is therefore highly important to keep up to date on the fundamentals of the stocks you hold for any likely negative headwinds.

Buying Stocks Using Fundamental Analysis

There are various methods and strategies to find out what a stock should be worth, but a straightforward metric that can be used to determine the value of a stock is a Price to Earnings equation. The Price to Earnings equation is simple and appears like this:

Stock Price / Full Year Earnings Per Share = Multiple

or

Multiple * Full Year Earnings Per Share = Stock Price

Stocks are forward looking so it is vital that you take a look at precisely what the future estimates are in order to discover what expectations happen to be being factored into a stocks share price. Using the second equation listed above, you can see that if you can establish a estimate of what a stocks future earnings per share is going to be, after which multiply it by a certain multiple, you can get a rough estimate of the potential upside of a stock. Precisely what multiple will we assign to a stock? Well there are numerous ways of thinking here but the most common can be a market multiple or perhaps a multiple in line with the companies growth rate.

A market multiple is the multiple that the market, for this example the SP-500, is trading at. The SP-500 happens to be trading around a 14 multiple, so we can use that as a conservative number. However a more accurate model to calculate a stocks multiple is usually to look at the stocks growth rate. A conservative approach here is to use a multiple that is equal to a companies future growth rate. An illustration would be a stock growing at 20% should use a 20 multiple to take into account the growth rather than the 14 multiple the SP-500 is trading at.

Using Yahoo Finance’s Analyst Estimates section, it is possible to type in a stock’s ticker symbol and see information such as the analysts future earnings per share and growth rate estimates. Looking at the below image you can see that next years earnings estimate for Apple (AAPL) is $47.76 . In the bottom pane you may also note that its growth rate next year is predicted at 11.4%.

Using the calculation above you can calculate the following price target as 11.4 * $47.76 = $544.46. Apple’s closing price as of 3/8/2012 was $541.99, therefore you could reason that Apple was fairly valued at that time with not a lot of upside. Nonetheless its also crucial to notice a companies earning history to see if it usually beats analyst targets or disappoints. As you can see in the middle pane labeled “Earnings History”, Apple is recognized for solidly beating even the highest of analyst estimates. If we assumed that Apple would carry out the same down the road, we could use the high wall street analyst of $53.00 as opposed to the average that we used previously. In this instance we receive 11.4 * $53.00 = $604.20. This would indicate a possible upside for Apple at around 11.5%. There is always more to the story than a stocks Price to Earnings equation, but this is meant to be a introductory example to one of many methods that professionals employ to calculate a stocks future price on a fundamental basis.

Summary

Fundamental analysis at its core is an excellent starting place to help you narrow your watch list of stocks from the many choices to the limited number that are well worth buying. While there are many different methods of fundamental analysis like growth investing and value investing, understanding a companies products or services, as well as its prospective future earnings is key for long term investors. Successful investors coming from all backgrounds, whether it be Warren Buffet employing a value approach, or William O’ Neil utilizing a growth approach, have integrated fundamental analysis within their investing system and have gone on to be incredibly successful in the markets.

To learn more about how to buy stocks you should definitely check out How to Buy Stocks Headquarters.