What is fundamental analysis? A comprehensive guide

Analyzing stocks is considered both a skill and an art since different evaluation methods have sometimes made investors look foolish. Some investors look at the financial data under the hood of a particular publicly traded company. Others look for patterns in the short-term gyrations of stock prices. And then you have buy-and-hold investors who simply buy index funds and never even look at company or stock price data. 

In this article, we'll define fundamental analysis, discuss the differences between fundamental and technical analysis, and explain how fundamental stock analysis can help investors make informed decisions when buying individual company shares.

Understanding fundamental analysis

What is fundamental analysis and technical analysis when it comes to stock selection? Both attempt to predict the future movement of stock prices but with different methodologies and time frames. However, fundamental analysis focuses more on company and industry data than stock price points. Investors using fundamental analysis are familiar with different ways of researching investments in public companies, such as reading income statements, 10Ks or mutual fund prospectuses.

Investors using fundamental analysis tend to have long-term timeframes and use a top-down research approach. When exploring the fundamental analysis of a company, investors examine the overall state of the economy, the prospects of the specific industry and the particulars of the business. Stock fundamental analysis involves reading income statements and balance sheets, listening to quarterly conference calls and using certain statistics and ratios to predict company performance.

Fundamental analysis vs. technical analysis

What is fundamental investing compared to technical investing? Fundamental investors want to own pieces of the companies they invest in, which is why those with a long-term view prefer this method. Technical investors are usually day or swing traders looking to ride short-term momentum waves. They don’t care much about the underlying business, just the direction of the price action.

Fundamental analysis

To learn fundamental analysis, you'll need to get comfortable with lots of financial terminology. At the heart of all fundamental analysis is the goal of finding the company's intrinsic value. Markets might be efficient most of the time, but fundamental analysis proponents believe they can find undervalued (or overvalued) stocks by examining the underlying financial data. 

For example, one of the most commonly used (perhaps overused) metrics in fundamental analysis is the price-to-earnings ratio or P/E ratio. To find the P/E ratio, you divide the price of a stock share by the company's earnings-per-share figure. The resulting ratio shows how expensive the stock is compared to the firm's earnings. Investors use P/E ratios to evaluate companies across time or to compare competing companies in the same industry.

Technical analysis

Technical analysis isn't the opposite of fundamental analysis, but it's the preferred tool of short-term traders who are more concerned with day-to-day price movements than long-term trends. Technical analysis ignores company data like P/E ratios, sales growth and debt levels. Instead, technical traders look for price patterns with tools like moving averages, volume and various indicators on stock charts.

Support and resistance are two key concepts for technical traders. Support refers to a price point where buyers outpace sellers, commonly used to find short-term lows, which make ideal trade entry points. Conversely, resistance is a price point where sellers have the advantage and short-term upswings often lose steam in this area. Since these timeframes are often days (or even hours or minutes), the fundamental factors of the company don't matter much in the analysis.

The importance of fundamental analysis

Why is it important to learn fundamental analysis of stocks? Fundamental analysis allows investors to analyze business performance when selecting a stock portfolio. Here are two of the most important features of fundamental analysis:

Long-term investment

Proponents of fundamental analysis in investing believe that stocks run into occasional "mispricings" where the stock price doesn’t match the company's intrinsic value. You can find these mispricings using fundamental analysis, such as a tech company with growing profits that hasn’t been rewarded with an ascending stock price. The market corrects these mispricings over a long time horizon, but investors analyzing fundamentals can purchase undervalued shares and, in theory, outperform market averages.

Risk management

Fundamental analysis doesn't just help find undervalued stocks; it can also provide a warning sign to sell a stock before a downturn occurs. Mispricings also occur on the downside, where a business with degrading sales or management trouble doesn't always have its issue reflected in the stock price. Fundamental investors look for declining sales growth or increasing costs as a sign to avoid certain stocks (or sell holdings in anticipation of a downturn).

Key components of fundamental analysis

So, what to look for in fundamental analysis? Not every investor trusts the same metrics or digs as deeply into statements or conference calls. However, all investors researching fundamental analysis stocks should familiarize themselves with the following components:

Financial statements

Financial statements include three documents, easily located through MarketBeat's analysis tools.

• Income statement: The income statement is distributed quarterly with earnings and shows the company's revenue, expenses and profits. The sheet is where the company explains what it earned, what it owes and how much it costs to operate the business and sell products or services.
• Balance sheet: A company lists its assets and liabilities on the balance sheets, where fundamental investors can determine how much debt and other obligations the business has. Fundamental investors will avoid companies with too much debt or liability.
• Cash flow statement: Not all assets and profits are liquid, so a cash flow statement is another important document in fundamental analysis. The cash flow statement is where you'll find capital expenditures, debt issuance and repayment and stock buybacks. Companies with cash flow problems may have trouble meeting future obligations, which is a warning sign for investors using fundamental analysis.

Economic indicators

Individual company performance isn’t the only thing directing stock prices. Economic data can hint at future business profits in specific sectors and industries. For example, inflation has been one of the hottest economic data points since the end of 2021. Inflation measures a few different metrics, most notably the Personal consumption expenditure (PCE) and Consumer Price Index (CPI). Companies that can maintain pricing power often do well during inflationary periods, and fundamental analysis can provide insight into which companies can maintain their profits.

Industry analysis

Investors use fundamental analysis of stocks not just to compare industries but also to compare competing companies within the same stock sector. For example, an industry like the consumer staples sector isn’t as concerned with profit growth as the tech sector since consumer staples products often have inelastic demand. Financial data like the cost of goods sold (COGS) will be more crucial in determining the health of stocks in this sector.

If you compare two consumer staples stocks, numbers like COGs or margins can help determine which company is a better buy. If it costs The Proctor and Gamble Co. NYSE: PG more to sell household products than The Colgate-Palmolive Co. NYSE: CL, then fundamental investors may prefer to own CL shares over PG shares on the expectation that more revenue will turn into profit at Colgate-Palmolive.

How to conduct fundamental analysis

Now that you know the goal and tools of fundamental analysis, here's how to start your own analysis. Be sure to choose stocks and industries you can decipher with the available data and have tight rules regarding when to buy and sell.

Gather data

First, you'll need to gather data for your analysis, and MarketBeat has plenty of tools. The high and low P/E calculators can locate stocks that are under or overvalued based on earnings, or you can simply use the data on individual stock pages to locate key ratios. Here's some fundamental data for retailer Target Corp. NYSE: TGT.

Financial ratio analysis

Investors can also use MarketBeat’s tools to evaluate financial ratios. We already discussed the P/E ratio above, so here are a few more important rates to know:

• Price-to-book value: Compares the company's market capitalization to the net asset value.
• Price-to-sales ratio: Much like P/E ratio, except uses revenue instead of profit for the denominator. It evaluates businesses that may have incurred short one-time expenses.
• Debt-to-equity: Too much debt can drag down a company’s performance if more and more revenue is sacrificed to repay it. The debt-to-equity rate compares assets and liabilities in an easily-disseminated fashion. A debt-to-equity rate over one implies more debt than assets.

Valuation methods

Finding a company's intrinsic value is fundamental analysis's primary end goal. Different valuation methods like P/E, P/B or P/S all attempt to answer the same question: Is the current stock price reflecting the actual future value of the company? Using the data gathered in your research, you can compare stocks across timeframes and industries using financial ratios. 

Real-world examples

Imagine you compare two stocks in the same industry: The Coca-Cola Company NYSE: KO and PepsiCo Inc. NASDAQ: PEP. Most people can’t even tell the difference between Coke and Pepsi, so how do you choose one stock over another? By using fundamental analysis!

In this fictional scenario, imagine KO trades at a P/E of 10 and PEP trades at a P/E of 20. If the average P/E in the consumer discretionary sector is 15, KO is cheaper to own than PEP and well below the industry standard. A deeper dig into the financial statements might show that margins at Pepsi are declining, meaning that the company keeps less of its revenue as profit. You could add KO shares to your portfolio instead of PEP using this information.

Challenges and limitations

Fundamental analysis can teach investors about a company's financial health but doesn’t predict the future. A good company doesn’t necessarily mean a high-flying stock; many businesses don’t produce returns. 

For example, the COVID-19 pandemic set off a barrage of stock trading activity that retrospectively made little sense. Companies with no earnings saw meteoric stock returns, outperforming successful businesses with growth potential. Fundamental analysis is useful but won’t always produce winners, especially in markets like 2020, where fundamentals flew out the window.

Combining fundamental and technical analysis

Fundamental analysis is a tool for long-term traders, but those who don't mind mixing timeframes can use technical AND fundamental analysis in their trading. For example, some investors choose a long-term portfolio like a Roth IRA based on fundamental analysis and a short-term portfolio in a cash account where frequent trades occur.

Can these techniques evaluate the same stocks? Sure, but they won't reach the same conclusion. Fundamental analysis wants to know about business performance; technical analysis wants to find patterns in stock prices. Neither practice works all the time, but investors can still use both to their advantage.

Fundamental analysis helps long-term investors

Jim Morrison once sang that the future's uncertain and the end is always near. The second part of that lyric might be a little too much doom and gloom, but the uncertainty of the future is why investors use tactics like fundamental analysis of the stock market to make predictions. If it were easy to predict stock prices in the long or short term, we wouldn't have a stock market! Even the best fund managers like Peter Lynch or Jim Simons knew the limitations of their strategies and theories.

In short, fundamental analysis in trading is a tool like any other. It can provide helpful insight into the financial health of a particular company, but it can never truly predict where the stock price will go next. Some businesses that turn steady profits aren't rewarded in the stock market. In contrast, others with poor fundamentals or bad management can defy logic and double up quickly (looking at you, meme stocks). Fundamental investing might be more science than art, but it still doesn’t clarify the future of individual stock prices.

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