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Fundamental analysis involves researching a company’s financial statements to determine if it is financially sound and will continue to make money. It is viewed as a more conservative approach to stock selection than technical analysis, which focuses on predicting short-term price movements. A combination of both approaches can be used for stock selection and timing.
Fundamental analysis is a type of stock selection discipline. If you do extensive research on a company’s financial statements before you decide to buy shares of the company for investment purposes, you are said to be following a fundamental analysis approach to investing. Another very common approach is technical analysis, which is almost the opposite type of approach.
A fundamental analysis approach tries to determine if the company is financially sound and will continue to make money. A technical analysis approach to investing is almost entirely related to the performance of the share price over time and attempts to predict what it will do in the future based on this. Sometimes the two approaches are combined, with a fundamental analysis approach used to select the stocks and a technical analysis approach used to time the investment in the stocks of interest.
When you do a fundamental analysis of stocks of interest, you are trying to determine if the stock is worth investing in. In this approach, you look at how well the company is performing financially. What are the company’s profits? Have they been growing? How does the ratio of stock price to earnings per share, the P/E ratio, compare to other similar companies?
This approach attempts to answer some basic or fundamental questions about the financial health of the company and the industry in which the company operates. How big is the company? How long have you been in business? How is the management of the company? What is the outlook for the industry the company is in?
Fundamental analysis is generally viewed as a more conservative approach to stock selection than technical analysis. It is certainly a more exact science. The price earnings ratio is easy to calculate; it is simply the price of each share of the stock divided by the earnings per share. The book value of the company can be easily determined from the company’s financial statements, and earnings are easily calculated from the financial records.
By contrast, the math behind most technical analysis is much more complex and often requires much more judgment on the part of the investor. In a technical analysis approach, the investor tries to predict the behavior of the crowd, while a fundamental analysis simply tries to determine if the company has been making money and at what rate it is likely to continue to make money. The short-term stock price is not that important in a fundamental analysis, since the theory is that if the company is making money and continues to make money, the stock price will eventually rise. A technical analysis approach is much more concerned with short-term price movements.
Stock investing is much more likely to be successful if a systematic approach is used. A fundamental analysis approach is the easiest to understand and learn, and as such is perhaps the best place to start for a beginning investor. However, both approaches have their strengths, and knowledge of both will benefit any investor and result in better investment returns.
Smart Asset.
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