Fundamental Analysis: Reloaded
So, here we go again. Starting over the Fundamental Analysis series.
What is fundamental analysis? Fundamental analysis is the act of analyzing a company as a money-making business. The theory that drives this analysis is that, in the long run, a company’s stock price has to be directly related to its fundamental value as a business which can generate money for its owners (the stock holders). The most telling difference between fundamental analysis and technical analysis is a shift from price driven analysis of a stock to earnings driven analysis of a stock.
The use of technical indicators described in the Technical Indicators posts tell an investor when to buy based on price movements and trends. This kind of analysis is usually accurate in predicting, in the immediate to short run, whether there are people in the stock market willing to buy the shares hold for a higher price than they are currently trading at. The decision to buy is based exactly on whether or not analysis leads the investor to believe that he can buy today and find more eager buyers tomorrow.
Fundamental analysis, on the other hand, attempts to find an intrinsic worth for ownership of a company by trying to place a value on it through analyzing the company’s fundamentals – its earnings, assets, liabilities, revenues, etc. When done properly, fundamental analysis will tell an investor how much a stock (ownership in a company) should be intrinsically worth. The decision to buy the stock is then based on whether or not the investor can buy for a price lower than the value calculated through fundamental analysis.
One analogy that might be illustrative for the difference between a fundamentally driven investor and a technically driven investor might be that between a home buyer and a house flipper. The home buyer is like a value investor and wants to get the best deal possible on the house. He cares about whether the house is built on a solid foundation, has quality construction, and will be comfortable and hassle free all the years he chooses lives in it. He is relatively sure that it won’t lose value if he wants to sell it years later. The house flipper is like a technical investor and doesn’t really care that much about the house he is buying. Instead, the house flipper wants to know that real estate in the area is selling like hotcakes, that the comps in the area are high enough so he can make a profit, and he wants to protect his investment in the house only to the point that he can sell it to someone else for more money.
The question of which strategy will make you more money is debatable. But, fundamental analysis cannot be ignored as an important tool for anyone interested in investing. Fundamentally based investing is often taught through the use of ratios like Price to Earnings or Price to Book or Return on Invested Capital without any attention paid to the what, how, and why. Instead, people reading the “Learn to be Warren Buffett The Easy Way” books get a list of ratios and statistics to look at followed by tables of data claiming to show the use of those ratios and statistics has historically chosen the best performing stocks. When approached this way, fundamental analysis provides no real difference from technical analysis – merely a different set of numbers to focus on.
The goal in this series on Fundamental Analysis is to delve more into how to perform some fundamental analysis and valuation of your own or, if you are not willing to spend that kind of time on each investment, to at least understand why it is that people are so willing to trust reported ratios and statistics like the ones mentioned above. In the end, I will again try to put it all together into a simple strategy (or a few strategies) for finding investments similar to the Simple Breakout and Tend Reversal system I proposed after the technical indicators series.
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