Blog Post

Stock Fundamentals

Date Published: Mar 11, 2021

Person looking over investment charts

An important part of investing in stocks is learning and understanding the business you are looking to invest money in. In fact, one of the world's most successful investors, Warren Buffet, advises against investing in businesses you don't understand.

So, when you begin investing in stocks you do not want to go out and purchase stocks in companies whose business model is a mystery to you. Thoroughly study and educate yourself on the company those stocks represent and understand the company's business model (Artzberger, Read: 'Avoid These 8 Common Investing Mistakes' on Investopedia).

This is where stock fundamental analysis comes in, which involves examining the data that exists outside of studying the trade and price history of the stock itself or the technical analysis.

Fundamental analysis focuses on educating yourself on the company a set of stocks represents and learning about the company's business model. It allows you to gain knowledge on the company and really paint a clear picture on who that company is and the basic value of its shares. This research will help you with buying or selling the stock based on the information gathered.

Aspects to Assess a Company's Fundamentals

Below are a few popular indicators and things to look at to help you carry out a fundamental analysis for a company.

  • Cash Flow: Net amount of cash or cash-equivalents that goes into and out of a company. How efficient a company is at generating value for its shareholder is based off of its ability to create good cash flows or maximize long-term free cash flow. A positive flow shows that a company's liquid assets are going up, which will allow it to settle debts, reinvest, return money to shareholders, pay expenses, and put up a shield against future financial obstacles (Tuovila & Drury, Read: 'Cash Flow' on Investopedia).

  • Return on Assets (ROA): ROA, usually displayed as a percentage, is an indicator on how profitable a business is corresponding to its total assets. It supplies you with a picture on how skilled a company's management is at utilizing its assets to develop earnings (Hargrave, Read: 'Return on Assets - ROA' on Investopedia).

  • Conservative Gearing: This looks at the relationship, or ratio, of a company or business's debt to equity. Gearing highlights the degree to which a firm's activities are supported by lenders versus shareholders. Basically, it measures a company's financial leverage (Young, Read: 'Gearing' on Investopedia on Investopedia).

  • History of Profit Retention for Funding Future Growth.

  • Integrity of Capital Management for the Maximization of Shareholder Earnings and Return.

How it Works

Let's pretend that the stock market is a shopping mall and the stocks are items that are for sale in the various stores.

With a technical analyst approach you will focus on the crowds as an indicator on what items you should buy. So, you might watch shoppers flock to a shoe store. Then you will follow the crowd and purchase as many shoes as you can, influenced by the notion that a growing demand for shoes will increase their price.

When you take the fundamental approach you set your gaze on the actual products within the mall, instead of on the shoppers themselves. Shoppers are unreliable and don't have a good indication of the real value of the items. The fundamental view is a much more earnest approach as you patiently make your way through stores to find the best deals.

As a fundamental analyst, you might try to figure out the scrap value or individual components of the shoes such as the laces, material used, comfort, sole, and other individual features. Relating back to the stock market, this is like determining the book value or liquidation price of a company.

Fundamental analysts will continue to look further into the shoe and its quality wondering how long the shoe will last. They will closely look over the specifications of a pair of shoes and the manufacturer's warranty, as well as use consumer reviews as a reference tool.

Continuing the research on the shoe from the fundamental approach, you would also try to learn about the performance of the shoe. Is it for hiking, running, training, or casual/dress, as well as its weight, flexibility, support, shock absorption, and other factors. This is similar to looking into the forecast earnings and dividends that are supplied by a company's income statement.

Then you will put together all of the data from your research and develop an intrinsic value or a value that is separate from the sale price of the shoe. If the sale price of the shoe is $30 and your calculated intrinsic value is $50 for the shoe, then you will move to purchase the item.

If your intrinsic value is less than the shoe sale price of $30, you will move to sell any shoe you already own or wait for the sale price of the shoe to drop before deciding to buy more pairs of shoes.

The Negative of Good Fundamentals

Good research into a stock's fundamentals and the fundamental analysts approach can protect you from the dangers of day-to-day market fluctuations, help you pick up on the market's mistakes, and know when a price is wrong. However, knowing a stock is undervalued does not mean that it will reach the intrinsic value you have for it any time soon.

Unfortunately, the stock market is not so simple. Real share price behavior constantly calls into question almost all of the stock holdings and the most independently minded investor can begin to have doubts on the quality of fundamental analyzing.

In short, there is no definitive, sure fire formula or method to figure out an exact intrinsic value. In times when the market is at a low point and outlook is uncertain, you really need to have a good grasp on investing and what you are doing.

Know Your Investments

If you are looking at investing in individual stocks, fundamental analysis is going to be an important practice to get into the habit of doing. It will help you to educate yourself on the company those stocks represent, and understand their business model.

If any of the fundamentals that influenced you to invest in a company change, perform additional research on the company to see if it is still a good fit for you.

Utilizing fundamental analysis and learning the terminology and techniques in your investing endeavors will help give you the confidence you need in using financial information. Furthermore, it will guide you in picking the right stocks to invest in and give you a better understanding of the investment world (McClure, Read: 'What Are Stock Fundamentals?' on Investopedia).