Investing Using Fundamental Analysis
Fundamental analysts use a variety of sources and methods to rate companies. Sources might include company reports, newspaper reports and gossip.
Most fundamental analysts also take account of the broader economy in their investing decisions. Some factors a fundamental analyst might study in relation to a company are:
There are many possible factors. These change in importance according to the nature of the company being studied.
Discounted Cash Flow
A very common method employed by fundamental analysts is to calculate a company's discounted cash flow or dcf.The analyst looks at a company's track record of profit growth. He or she then makes an informed guess about growth prospects over the next few years and the effect of that growth on the earnings per share for stockholders.
The analyst discounts the cash flow by comparing the stock's earnings per share with the "safe" yield from a benchmark investment - such as government bonds. After the company's earnings have been discounted, the analyst is able to place a value on the company's shares.
If the shares are trading significantly below the dcf value they should be bought. Otherwise they should not.
A fundamental analyst sells a stock when it no longer offers good value compared with their chosen benchmark.
As an alternative to dcf, is a simpler method such as PEND is capable of selecting companies with good fundamentals for more detailed scrutiny.
What is meant by significantly below dcf value?
Most fundamental analysts know their art is inexact. Warren Buffett is fond of saying he would rather be "approximately right than precisely wrong".For this reason, fundamental investors often look for a margin of safety in their purchase prices. They get this by only buying shares trading at least, say, thirty percent cheaper than the dcf "buy" price.
Margin of safety - dangerous for inexperienced investors
"Inexperienced investors get it wrong - they buy stocks that look cheap before they have developed the skills to realize that these stocks are not cheap."Investingator 2005
In principle, having a margin of safety sounds like a great idea. Surely you can't lose? Unfortunately you can, and many will testify to this.
There are often good reasons for a stock to trade below its apparent value. The market looks relentlessly to the future. Simplistic dcf valuations rely heavily on assumptions that the future will look like the past - and inexperienced investors become very good at churning out simplistic dcf valuations.
Often the inexperienced analyst will say "the company's profits have grown by 15 to 20 percent for five straight years. Therefore profits will continue to grow by 15 to 20 percent for the next five years."
BUT if the company grows at only two percent for the next few years - this happens more often than you would like it to - the dcf will have grossly overestimated the price you should have paid.
Carrying out reliable discount cash flow valuations is notoriously difficult because it depends on your ability to read the future. Warren Buffett is the world's most famous fundamental investor. He is successful, at least in part, because he has applied dcf valuations to companies whose futures he has been able to predict reasonably accurately.
Summing it up - Fundamental Analysis
If you want to be a successful fundamental analyst, your first step should be to learn to read financial reports. You then need to develop the ability to tell which companies' futures are the most predictable - these are the best stocks for fundamental investing. You also need to learn to predict how developments in the broader economy will affect your stocks.It's fair to say that pure fundamental analysis can make life unnecessarily hard for most investors. Stockbrokers employ large numbers of economics and accounting graduates to carry out fundamental analysis and stock valuation. Although many authors like to propagate the myth that you can easily beat such analysts, the reality - measured by the success of small investors in the stock market - is that most small investors invest rather poorly.
The combination of a basic fundamental stock-screening method, such as PEND, with a simple technical analysis method, such as TREND, can be an effective method for small investors.