What’s Fundamental Analysis
Fundamental analysis is a method of deciding on stocks by examining fundamental measurements such as earnings per share, revenue growth, cash on the balance sheet, increasing debt, etc, to determine what you believe a stock will be trading at in the long run. By comparing the value you feel the stock ought to be worth, also referred to as intrinsic value, you could make a decision on if the stock is at a good price to acquire today depending on the current price it’s trading at. Where it may possibly get complicated is in how we determine what a companies intrinsic value is.
What Fundamental Analysis Isn’t
Fundamental analysis isn’t a good forecaster of short term price movements. Usually, fundamental shareholders are intermediate to long term investors simply because they need time for their thesis to play out. Many things can happen within the markets from a day to day perspective, but over the longer term, stocks with positive fundamentals have a tendency to trend higher in price and reap rewards for longer term holders.
Advantages to Fundamental Analysis
The main advantage to making use of fundamental analysis is that you can have real certainty behind the stocks you hold. By learning and assessing a stocks long term story, it is possible to better understand the vision of where the company could potentially be in the future. If you find great fundamentals like increasing earnings per share and revenue growth, you are more prone to keep the stock for the big 50 to 100% gains and not be shaken out by small 5-10% pullbacks which come on the way. Another advantage is that if you are using a “value” approach, fundamental investors are usually the first to buy really beaten down stocks that could net big percentage profits over the subsequent years. If you can find stocks which are trading at deep discounts, aka have good “value”, you can capitalize on huge stock returns before a stock even comes on the radar of a technical analyst.
Problem with Fundamental Analysis
Fundamental analysis can be quite risky if you do not use proper risk management. Calculating a companies intrinsic value involves some type of prediction or anticipation of what an organization will earn down the road. One cloud that hangs over all forecasts of future estimates is the economy. When there is a tough economy, like there was in 2008, future earnings estimates of almost every company can come down and therefore you will have to adjust your expectations of a stocks future price. If you don’t manage your risk, or have a spot where you cut your losses, you may wind up riding stocks all the way down to $0.00 as numerous did with banking stocks in 2008. It is therefore highly important to keep up to date on the fundamentals of the stocks you hold for any likely negative headwinds.
Buying Stocks Using Fundamental Analysis
There are various methods and strategies to find out what a stock should be worth, but a straightforward metric that can be used to determine the value of a stock is a Price to Earnings equation. The Price to Earnings equation is simple and appears like this:
Stock Price / Full Year Earnings Per Share = Multiple
or
Multiple * Full Year Earnings Per Share = Stock Price
Stocks are forward looking so it is vital that you take a look at precisely what the future estimates are in order to discover what expectations happen to be being factored into a stocks share price. Using the second equation listed above, you can see that if you can establish a estimate of what a stocks future earnings per share is going to be, after which multiply it by a certain multiple, you can get a rough estimate of the potential upside of a stock. Precisely what multiple will we assign to a stock? Well there are numerous ways of thinking here but the most common can be a market multiple or perhaps a multiple in line with the companies growth rate.
A market multiple is the multiple that the market, for this example the SP-500, is trading at. The SP-500 happens to be trading around a 14 multiple, so we can use that as a conservative number. However a more accurate model to calculate a stocks multiple is usually to look at the stocks growth rate. A conservative approach here is to use a multiple that is equal to a companies future growth rate. An illustration would be a stock growing at 20% should use a 20 multiple to take into account the growth rather than the 14 multiple the SP-500 is trading at.
Using Yahoo Finance’s Analyst Estimates section, it is possible to type in a stock’s ticker symbol and see information such as the analysts future earnings per share and growth rate estimates.
Using the calculation above you can calculate the following price target as 11.4 * $47.76 = $544.46. Apple’s closing price as of 3/8/2012 was $541.99, therefore you could reason that Apple was fairly valued at that time with not a lot of upside. Nonetheless its also crucial to notice a companies earning history to see if it usually beats analyst targets or disappoints. As you can see in the middle pane labeled “Earnings History”, Apple is recognized for solidly beating even the highest of analyst estimates. If we assumed that Apple would carry out the same down the road, we could use the high wall street analyst of $53.00 as opposed to the average that we used previously. In this instance we receive 11.4 * $53.00 = $604.20. This would indicate a possible upside for Apple at around 11.5%. There is always more to the story than a stocks Price to Earnings equation, but this is meant to be a introductory example to one of many methods that professionals employ to calculate a stocks future price on a fundamental basis.
Conclusion
Fundamental analysis at its core is an excellent starting place to help you narrow your watch list of stocks from the many choices to the limited number that are well worth buying. While there are many different methods of fundamental analysis like growth investing and value investing, understanding a companies products or services, as well as its prospective future earnings is key for long term investors. Successful investors coming from all backgrounds, whether it be Warren Buffet employing a value approach, or William O’ Neil utilizing a growth approach, have integrated fundamental analysis within their investing system and have gone on to be incredibly successful in the markets.
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