In a landscape overflowing with schemes to get rich quickly and ludicrous market noise, the route towards creating wealth seems blinding. New investors are often swept up in speculative fashions and left only to wonder why their portfolios are not performing by their expectations. If you want to create enduring wealth and make informed decisions, you need to stop chasing fleeting fashions and begin to build your investing strategy properly. The proper way to build your investing strategy is on a firm foundation: fundamental analysis.
This isn’t about timing the next big stock jump or perfectly timing the market. It’s about understanding what a business is worth so you can buy and sell with certainty and clarity. You can think of fundamental analysis as the blueprint for your investing journey – it is an intricate blueprint that navigates through the maze of the market, identifies undervalued companies and not-so-amazing companies that have been overhyped.
What Exactly Is Fundamental Analysis?
Fundamental analysis, at its core, involves assessing a company’s inherent, true value by evaluating its financial statements, management team, industry and economic equilibrium. Unlike technical analysis, where price charts and trading patterns are the main focus, fundamental analysis examines companies behind their stock price to understand the ‘why.’
Think about whether you are in the real estate market and are considering buying a house. Would you look at the curb appeal and decide that is enough? Or would you consider the foundation, plumbing, electrical work, and neighbourhood? Fundamental analysis is akin to examining that house in detail – knowing what it is worth, and not just what it is worth in the market.
Why This Blueprint is Essential for Smart Investing?
- Rational Decision-Making: Fundamental analysis provides you with a strong process to proceed in the financial markets rationally. Instead of hunches and leads from friends, you are making decisions based on proof and principles.
- Wealth Creation: Thoughtful investing is seldom about quick wins. It is about compounding money over time. Fundamental analysis helps you find companies with strong financial stability and growth potential, which makes them reliable long-term holdings.
- Risk Control: Knowing a company’s financial stability, its debt levels and competitive position allows you to discern potential dangers, and in turn limit your risk.
- Reducing Speculative Behaviour: When you understand the business, you are better able to resist fear and hysteria, enabling you to be more disciplined as an investment to follow your plan consistently.
- Exposing Mispriced Investments: At times, the market may misprice a company. If you dig a little deeper into their fundamentals, you can find completely mispriced investments before the rest of the market does and capture a substantial gain.
The Key Components of Your Fundamental Analysis Blueprint
There are several crucial areas that you need to put focus on, and you can also enrol in our Advanced Level Fundamental Analysis Certificate Course to master it.
1. Financial Statements
These are the meat and potatoes of your analysis. There are three primary statements that you will share your attention with:
- Income Statement: Also known as the Profit & Loss (P&L) statement, it provides a summary of a company’s revenues, expenses, and profit or loss over a time period (i.e., a quarter or year). You will often be focused on revenue growth, gross profit, operating income, and net income (earnings per share), and you will want to see consistent profitability and growing profits.
- Balance Sheet: It takes a snapshot of a company’s assets (what it has), liabilities (what it owes), and shareholder equity (the ownership interest in the company) at a point in time. You want to see healthy current assets against current liabilities (liquidity), manageable levels of debt, and growing shareholder equity.
- Cash Flow Statement: It highlights how much cash the company is generating and using for a period. This document is especially critical since profits as reported in an income statement do not always reflect cash. You will focus on cash flow from operations, which reflects the cash generated from its business’s normal operations. Strong and positive operating cash flow is an excellent sign.
2. Financial Ratios
Ratios allow you to evaluate companies, measure trends, and assess performance against industry competition. Some significant ratios to use include:
- Price-to-Earnings (P/E) Ratio = Stock price per share / Earnings per share. The P/E ratio depicts how much each dollar of earnings is being charged to investors.
- Debt-to-Equity Ratio = Total Liabilities / Shareholder Equity. A company’s leverage, one more time, lower, is better.
- Return on Equity (ROE) = Net Income / Shareholder Equity. The efficiency of a company uses shareholders’ investments to generate profits.
- Current Ratio = Current Assets / Current Liabilities. Measures cash liquidity short term.
3. Management Quality
Even if the financial statements are terrific, it’s irrelevant if the management team is not trustworthy or competent. Investigate the leadership team. What is their experience? What is their track record? What is their integrity? What is their vision? Transparent answers should be available for investors to assess.
4. Industry & Economic Outlook
A terrific company will have a tough time if the overall industry is on a decline. Evaluate the growth potential of that industry. For instance, assess the competitive nature of the industry and regulatory environment, as well as how the broader economic direction may affect the company’s growth potential. What is being produced in a growing market? Does the company have a competitive advantage (a “moat”)?
Conclusion
Don’t feel too daunted. Start small. Choose a business you know and get familiar with its latest annual report (10-K in the US or equivalent in other markets). Really, devote your attention to understanding the basics of the financials and analysing a few key ratios. There are plenty of free resources and sample reports available online to get you up to speed on each piece.
Keep in mind, fundamental analysis is a journey, not a destination. It is a journey that requires patience, effort, and a willingness to learn infinitely. But by taking this approach, you are not just buying stocks; you are creating an investment in the business you bought a stake in and building a portfolio based on real value, while working towards simply becoming a good investor.
Would you like to explore other parts of fundamental analysis, such as balance sheets and cash flow statements? I have a lot more detailed guides and ideas over on my blog, “Fundamental Analysis In Stock Market!” Read it now for more information.
