Why understanding fundamental analysis is important for investing in stocks?

Fundamental analysis:

Why understanding FA is important? 

FA cannot offer you the magic keys to sudden or instant wealth. If that were true, the Professors of Finance will all be fabulously rich! What FA can do is to provide sound principles for formulating a successful long-range investment program. FA are proven methods that have been used by millions of successful investors.

The motivation for investing in stocks is obvious. It is to watch your money grow.

Why then, for every story of great success in the market, there are dozens more that don't end so well!!!!

More often than not, most of those investment flops can be traced to:

1. Bad timing
2. Poor planning
3. Failure to use common sense in making investment decisions.



Intrinsic Value

The entire concept of stock valuation is based on the idea that all securities possess an intrinsic value that their market value will approach over time.

Security analysis consists of gathering information, organizing it into a logical framework, and then using the information to determine the intrinsic value of common stock.

Given a rate of return that's compatible with the amount of risk involved in a proposed transaction, intrinsic value provides a measure of the underlying worth of a share of stock. It provides a standard for helping you judge whether a particular stock is undervalued, fairly priced or overvalued.



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The aims of fundamental analysis are to determine the asset's intrinsic value and its future growth potential.

Objective of Fundamental Analysis: To determine a company's intrinsic value or its growth prospects.

Fundamental analysis is forward looking even though the data used is by and large historical.  


The objective of fundamental analysis is to determine:
- a company's intrinsic value, or
- its growth prospects.  


This intrinsic value can be compared to the current value of the company as measured by the share price.  If the shares are trading at less than the intrinsic value then the shares may be seen as good value.


Many people use fundamental analysis to select a company to invest in, and technical analysis to help make their buy and sell decisions.


The analysis of an individual company has two components:

-  The 'story' - what the company does, what its outlook is
-  The 'numbers' - the financials of the company, balance sheet and income statement and ratio analysis.

Always remember that behind all the numbers is a real business run by real people producing real goods and services, this is the part we call "the story".

It is unlikely that you will need to do the number crunching for every company, your time will be more profitably spent developing the company story.  Balance sheets and ratio analysis, both historical and forecast, can be obtained from either a full service or discount stockbroker.


Before trying to leap into the calculations behind fundamental analysis there aresome basic questions that are worth considering as a starting point:

1. Where is the growth in the company coming from?
2. Is the growth being achieved organically or through acquisition?
3. Is turnover keeping pace with the sector and with competitors?
4. What about the profit margin - is it growing?  Is it too high compared to competitors?  If it is too high then new competitors could enter on price reducing margins.  Low earnings could suggest control of the cost base has been lost or factors outside the company's control are squeezing margins.
5. To what extent do profits reflect one-off events?
6. Will profits be sustainable over the long term?

Companies are multidimensional.  For example, debt funding may have increased - this may be a positive move if the funds produce new productive assets.

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The objective of fundamental analysis is to determine a company's intrinsic value or its growth prospects.

Warren Buffet's strategy on technical analysis

Warren Buffet's strategy on technical analysis
Apr 05 '00

After much research and experience in investing I've discovered a simple strategy which works very well for profitable investing. It's a composite of Charles Schwab's and Warren Buffet's strategy. As you may know, Warren Buffet started with a little investment decades ago and now he's the third richest man in the world with over $30,000,000,000 in stock in the company he built. Charles Schwab is the genius who began the most successful off-price brokerage in the world. Here's what they say about investing and technical analysis:

Rule number one: Buy a company you'd be willing to hold for a lifetime.

When you put your money in a stock, you become an owner of that firm. You're essentially buying part of it and you reap the profit from the shares you buy in terms of earnings per share. Then the company may pay out those earnings per share in dividends or invest back into the company for growth. Make sure that you're buying a firm that you can depend on, even when the market is down. Investing isn't about the quick in-and-out schemes that lose most day-traders money. That's called gambling. Investing is putting your trust and your resources into a firm which you're willing to commit your hard-earned money to. This leads to my next point.

Rule number two: Ignore technical analysis.

Technical analysis is used to predict whether or not a stock will go up or down in the short term. Some people think that they can ignore the fundamentals of the companies they buy based on technical analysis and end up losing large amounts of money. Yet, no responsible financial advisor would recommend or practice buying based solely or largely on technical analysis. That practice is used for what I defined to be gambling. Essentially relying on technical analysis involves looking at the volume of trading, advances/declines in the share price, and trying to determine whether or not the price will continue upward or reverse. For example, a lot of people buy or sell based on momentum. They jump on the bandwagon or abandon ship with the rest of the crowd. Yet, these fluctuations based on the herd mentality do less for those playing on technical analysis and more for the investor who looks for good value in shares. For, often people selling on technical analysis overshoot and cause a stock's value to be worth less than its fair value. Thanks to people who get burned on these losses, investors find unique opportunities to snatch up great comanies at bargain-basement prices.

Rule number three: Focus on the Fundamentals.

You cannot accurately predict the short term price fluctuations of stocks. Let me repeat myself: You CANNOT accurately predict the short term price fluctuations of stocks. If you could, those stock experts working at Merrill Lynch and Goldman Sachs wouldn't be working. Believe me: they've got a lot more experience than you or I do, and they're not gambling. So, instead of "investing on luck" or momentum, take control and do your research. Find out whether the company is consistantly outpacing the industry. See what the price to earnings ratio is and whether it's being undervalued. Find out whether earnings per share has been increasing or decreasing. See what the financial community thinks by examining analyst opinions covering the firm. All this information is easily accessable over the internet and free of charge. IF you do your homework your gains will be all but certain OVER TIME and you'll feel satisfied and proud with your investment choices. You may even become attached to your company and become well acquainted with it.

Rule number four: Buy long term

Besides your liklihood of making money going up, there are tax advantages to holding stocks long term. For one thing, if you simply hold onto your stock, you won't be taxed until you pull out and your investment can continue to compound, without erosion, until you sell. But, if you constantly buy and sell, then you're taxed on all your gains and you don't get to pay the lower capital gains tax. Instead, it's taxed as regular income, which is a higher tax rate. For most daytraders, tax erosion is one of the biggest problems with making any profit. But, if you do sell make sure it's because your company has been consistently underperforming. This leads to the next point:

Rule number five: Buy low sell high.

Lots of people buy stocks and when the price dips they get scared and sell. Other people see the price of their stock go up and buy more. But, this seems like reverse logic, right? If you own a good company, short-cited investors can drive down a stock price temporarily because of one below-expected earnings report or a bit of bad news. Let these be times for you to take advantage of other people's hysteria and buy at an attractive price.


Be smart in your investment decisions. Warren Buffet didn't find himself where he is today by buying on momentum or following technical analysis. Instead, it took research, patience, and commitment. If you can commit yourself to these same principles, you too will enjoy financial success.

http://www.epinions.com/finc-review-1935-D65AB19-38EAE41E-prod2

The Best Long-term Performers in any Probabilistic field emphasize PROCESS over OUTCOME.

Process versus outcome

Probably the best discussion that I've seen about this issue comes from Michael Mauboussin's book More Than You Know. Tellingly, it's the very first chapter of the book, and it opens with this quote from Robert Rubin:

Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome.

Mauboussin emphasizes the point, writing:

... investors often make the critical mistake of assuming that good outcomes are the result of a good process and that bad outcomes imply a bad process. In contrast, the best long-term performers in any probabilistic field -- such as investing, sports-team management, and parimutuel betting -- all emphasize process over outcome.

Winning the process game

Mauboussin very clearly lays out what the ideal goal of any investment process should be:

The goal of an investment process is unambiguous: to identify gaps between a company's stock price and its expected value. Expected value, in turn, is the weighted-average value for a distribution of possible outcomes. You calculate it by multiplying the payoff (i.e., stock price) for a given outcome by the probability that the outcome materializes.

What does this mean in practical terms? I often begin my investment research using a screen that identifies stocks with certain attributes. For our purposes here, let's say I'm looking for stocks that are currently out of favor with investors, so I set a screen looking for any stock that has declined by 20% or more over the past year and is currently trading at less than its tangible book value. Here are a few of the companies that pop up:

Company	Year-Over-Year Price Change	Price-to-Tangible Book Value
Banner Corp (Nasdaq: BANR)	(23.7%)	0.6
K-SEA Transportation Partners(NYSE: KSP)	(61.4%)	0.4
Oilsands Quest (NYSE: BQI)	(59.0%)	0.4
Hercules Offshore (Nasdaq:HERO)	(38.1%)	0.4
American National Insurance(Nasdaq: ANAT)	(26.5%)	0.6

Source: Capital IQ, a Standard & Poor's company.

To follow good process in evaluating these stocks, I'd first try to identify possible outcomes for them, and what those outcomes would mean for the stock price. 

1. Washington-state-based Banner, for instance, traded at more than twice its tangible book value prior to the financial crisis, so we could probably envision a case where shares recover to three or four times their current value. 
2. American National Insurance, meanwhile, has had cyclical valuation swings that have typically put its tangible book value multiple in a range of 0.5 to just above 1.0. In a scenario where toxic assets don't eat away at the balance sheet and investment returns start to increase, investors could see real upside here, too.
3. Of course, we also need to consider negative outcomes, as well. For example, investors would want to note that Oilsands Quest has never reported an annual profit. There may be a huge upside if the company finds a way to profitability, but its assets may not be worth all that much if it can only produce losses. 
4. Similarly, driller Hercules Offshore has been trying to find its footing again, but the need for a balance-sheet-strengthening capital raise may impact the value of currently outstanding shares.

Once you have a list of the potential outcomes for the stock in question, you can then weigh the potential for each of those outcomes to come to fruition, and end up with a good sense of whether the stock is a worthwhile investment.

http://www.fool.com/investing/general/2011/01/11/this-is-more-important-than-investment-profits.aspx

A Powerful Foundation for making intelligent decisions in the stock market: Knowledge of fundamentals of the company and human behaviour (psychology)

In recent years, behavioural finance has shed light on the psychology of stock prices and financial decisions by market participants.

Eventually, two main forces affect stock prices in the market:

• the fundamentals of the company, and,
• human behaviour.

Both forces have a role to play.

However, a combined knowledge of the two should make a more powerful foundation for making intelligent decisions in the stock market than relying on fundamentals alone.  

Many investors make dumb decisions by chasing stock prices.  Do you?  If so, what can you do about it?

We will get better answers by studying psychology than by boning up on finance alone.


The dumbest reason in the world to buy a stock is because it's going up.
- Warren Buffett

Related:

****Be a Better Investor

Understanding Fundamental Analysis

Understanding Fundamental Analysis

Understanding Fundamental Analysis (Part 2)

Understanding Fundamental Analysis (Part 3)

Understanding Fundamental Analysis (Part 4)

Understanding Fundamental Analysis (Part 5)

Understanding Fundamental Analysis (Part 6)

Looking at the investment world by studying the numbers. (2)

Studying the numbers

That a company makes a popular product doesn't mean you should automatically buy the stock.  There's a lot more you have to know before you invest. 

• You have to know if the company is spending its cash wisely or frittering it away. 
• You have to know how much it owes to the bank. 
• You have to know if the sales are growing, and how fast. 
• You have to know how much money it earned in past years, and how much it can expect to earn in the future. 
• You have to know if the stock is selling at a fair price, a bargain price, or too high a price.

You have to know if the company is paying a dividend, and if so,

• how much of a dividend, and
• how often it is raised.  

Earnings, sales, debt, dividends, the price of the stock:  These are some of the key numbers stockpickers must follow.

People go to graduate school to learn how to read and interpret these numbers, so this is not a subject that can be covered easily in depth for others.  The best is to give a glimpse at the basic elements of a company's finances, so you can begin to see how the numbers fit together.

Investing is not an exact science, and no matter how hard you study the numbers and how much you learn about a company's past performance, you can never be sure about its future performance.  What will happen tomorrow is always a guess. 

• Your job as an investor is to make educated guesses and not blind ones. 
• Your job is to pick stocks and not pay too much for them, then to keep watching for good news or bad news coming out of the companies you won. 
• You can use your knowledge to keep the risks to a minimum.

Consistently losing money in stocks - don't blame the stocks, it is not the fault of the stocks. You need a plan.

When people consistently lose money in stocks, it's not the fault of the stocks.

Stocks in general go up in value over time.

In 99 out of 100 cases where investors are chronic losers, it's because they don't have a plan.

They buy at a high price, then they get impatient or they panic, and they sell at a lower price during one of those inevitable periods when stocks are taking a dive.

Their motto is "Buy high and sell low," but you don't have to follow it.

Instead, you need a plan.

The Process of Fundamental Analysis

http://spreadsheets.google.com/pub?key=thrIJu34ZkHzDDZwDLtNIHw&output=html

The figure outlines the 5-Step process of fundamental analysis that produces an estimate of the value.
In the last step in the diagram, Step 5, this value is compared with the price of investing.  This step is the investment decision.