Stock-Picking Strategies: Fundamental Analysis

The fundamental analysis of stocks is the cornerstone of investing – and the foundation of most of the strategies covered in this tutorial. It involves evaluating a security using quantitative and qualitative factors to answer questions such as:

• Are the company’s revenues growing?

• Is the company actually making a profit?

• Can the company beat its competitors in the future?

• Can the company repay its debts?

• And ultimately: Will the company’s stock be a good investment?

Financials

Fundamental analysts pay close attention to a company’s financial statements. After all, they reveal a lot about the current – and future – health of the company. The financials are where investors find many of the quantitative factors used in fundamental analysis. Key financials include a company’s balance sheet, income statement and cash flow statement – all of which provide valuable information to the fundamental analyst.

If you’ve ever looked at one of these statements, you know they can be overwhelming. Still, it’s worth taking the time to develop a set of preferred metrics – the numbers on those financials that mean the most to you. Some key numbers to look for include net income, profit margin, debt-to-equity ratio and the price-to-earnings ratio. (For a closer look, see Introduction to Fundamental Analysis and 12 Things You Need to Know About Financial Statements.)

The Theory Behind It All

The goal of analyzing a company's fundamentals is to find a stock's intrinsic value, a term meaning what you believe a stock is really worth – as opposed to the value at which it is being traded in the marketplace.  For example, if you estimate a stock is worth $50 based on your DCF analysis – and it’s currently trading at $30 – you know the stock is undervalued and it might be a good time to buy it.

Although there are many different methods of finding the intrinsic value, the premise behind all the strategies is the same: A company is worth the sum of its discounted cash flows. In plain English, this means that a company is worth all of its future profits added together. These future profits must be discounted to account for the time value of money, that is, the force by which the $1 you receive in a year's time is worth less than $1 you receive today. In simple terms, DCF analysis attempts to value a project, company or asset today, based on how much money it’s projected to make in the future, with the idea that the value is inherently contingent on its ability generate cash flows for investors. (For further reading, see Understanding the Time Value of Money). 

The idea behind intrinsic value equaling future profits makes sense if you think about how a business provides value for its owner(s). If you have a small business, its worth is the money you can take from the company year after year (not the growth of the stock). And you can take something out of the company only if you have something left over after you pay for supplies and salaries, reinvest in new equipment, and so on. A business is all about profits, plain old revenue minus expenses – the basis of intrinsic value.

The 'Greater Fool' Theory

One of the assumptions of the discounted cash flow theory is that people are rational, that nobody would buy a business for more than its future discounted cash flows. Since a stock represents ownership in a company, this assumption applies to the stock market. But why, then, do stocks exhibit such volatile movements? It doesn't make sense for a stock's price to fluctuate so much when the intrinsic value isn't changing by the minute.

The fact is that many people do not view stocks as a representation of discounted cash flows, but as trading vehicles. Who cares what the cash flows are if you can sell the stock to somebody else for more than what you paid for it? Cynics of this approach have labeled it the greater fool theory, since the profit on a trade is not determined by a company's value, but about speculating whether you can sell to some other investor (the fool). On the other hand, a trader would say that investors relying solely on fundamentals are leaving themselves at the mercy of the market instead of observing its trends and tendencies.

The Two Types of Investors

This debate demonstrates the general difference between a technical and fundamental investor. A follower of technical analysis is guided not by value, but by the trends in the market often represented in charts. So, which is better: fundamental or technical? The answer is neither. As we mentioned in the introduction, every strategy has its own merits. In general, fundamental is thought of as a long-term strategy, while technical is used more for short-term strategies. (We'll talk more about technical analysis and how it works in a later section.)

Most strategies in the following chapters are based on some aspect of fundamental analysis. Some of these strategies are easier than others to learn: The Dogs of the Dow strategy, for example, is simple enough that even the most novice investor could understand and execute with relatively limited effort. Most strategies, however, require significant time and effort to master, and becoming a proficient fundamental analyst should be viewed as a life-long journey.

For practice, the next chapter explains how to do discounted cash flow analysis.