MASTERCLASS Investing – How is Fundamental Analysis an Aid to Successful Investing?

 

How is Fundamental Analysis an Aid to Successful Investing?

How is Fundamental Analysis an Aid to Successful Investing?

Fundamental analysis is used as an aid to successful investing and is a process of analysing the financial statements of a business (Balance Sheet, Profit & Loss, Cash-flow Statement), as well as creating ratios of some of the figures, to determine the financial health and assess the management of the business before making an investment by comparing the results with other businesses.

Fundamental analysis is the examination of the underlying forces that affect the well-being of the economy, industry groups, and companies. The goal is to forecast future price movements. It can also include looking at the industry level, by examination of supply and demand forces for the products offered. And it is good to also look at the national economy – economic data to assess the present and future growth of the economy. To forecast future stock prices, fundamental analysis combines these 3 – economic, industry, and company analysis to derive a stock’s current fair value and forecast future value. If fair value is not equal to the current stock price, as it is in most cases, fundamental analysts will say that the stock is either over or under valued and the market price is expected ideally to move towards fair value.

Fundamental analysis attempts to determine the value of a company by analysing the financial data from the annual report and using other qualitative data about the company and the environment in which they operate. This value is often called ‘intrinsic value’.

Fundamental analysis assumes that over the long term, a stock price will reflect the company’s intrinsic value.

Definition – A sound fundamental definition comes from Investopedia.  They define fundamental analysis as:

A method of evaluating a security that entails attempting to measure its intrinsic value by examining related economic, financial and other qualitative and quantitative factors. Fundamental analysts attempt to study everything that can affect the security’s value, including macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management).

For further reading and an online video from Investopedia go to the fundamental analysis page. (from Australian Investors Association)

The Quantitative factors that are those capable of being measured or expressed in numerical terms, measures such as:

  • Revenue and growth of Revenue from year to year
  • Earning / Profit
  • Assets
  • Debts

These financial measures are commonly combined to produce fundamental or financial ratios that analysts can use to compare the company they are analysing to:

  • Prior trading period results
  • other companies in the same industry
  • the overall market

Well-known Ratios include:

  • Debt to Equity(DE)
  • Return on Capital (ROC)
  • Return on equity (ROE)
  • Dividend yield
  • Price to earnings ratio (PE)

The Qualitative factors are those that are not in numbers – more like assessments and opinions/evaluations. So they can be subjective, and may include:

  • Management performance and experience
  • Competitive advantage
  • Business model
  • Banding strength

Some of the Pros of fundamental analysis – can be objective (the quantitative parts), have a long-term focus, provide a guide/value

Some of the Cons include being subjective to our biases, the time involved to prepare/study, that market sentiment doesn’t always follow our own reasoning, our assumptions, data looks back so future can easily change the outcome.

To re-cap – Fundamental analysis is used as an aid to successful investing and is a process of analysing the financial statements of a business (Balance Sheet, Profit & Loss, Cash-flow Statement), as well as creating ratios of some of the figures, to determine the financial health and assess the management of the business before making an investment

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