What is fundamental analysis in stock trading?
You’ve probably heard of fundamental analysis in stock trading, or you may already use it yourself. If you’re not sure what it is, the best place to start is at the beginning.
What does fundamental analysis mean?
Fundamental analysis is a term used when analyzing and researching stocks and any security. The term itself means underlying value. Fundamental analysts determine the value of a company by looking at its actual business facts and data, such as earnings reports and financial statements, rather than market speculation. More specifically, fundamental analysts do this by reading parts such as revenue growth projections or cash flow forecasts.
Basics of financial statements
The basics of reading financial statements were just touched upon briefly above; however, they are important enough to explain in a little more detail. Financial statements are the essential tools fundamental analysts use to make their investment decisions. They contain three main pieces of information:
- The income statement shows how much money a company has made through sales and services and how much it has paid out that year or quarter. These reports typically show net income or loss for each period stated on the form, beginning with the most recent four quarters (quarterly/sales). In addition, data can be found regarding revenue growth from one month, quarter, or year to the next, as well as operating expenses and the number of employees over time.
- The balance sheet is a snapshot of a company’s financial position at a specific point in time. It is divided into two sides of the balance sheet, labelled assets and liabilities. The asset side reports how much money a company has invested in cash on hand, accounts receivable, inventory, fixed assets and goodwill. The liability side shows precisely what you would expect; any debt owed by the company.
- The statement of owner’s equity is also found here. It provides information about changes in net worth over time for a business entity. That means that if there are several stockholders in an LLC or corporation, they will each have their line item showing their portion of the business they own and any changes to that number.
The third and final part of fundamental analysis is identifying a company’s financial strengths and weaknesses. It requires an understanding of the industry involved, as well as what makes companies succeed or fail. For example, you can compare one public company with another; if Company A has a higher current ratio than Company B, Company A is currently in better shape than Company B because its current assets divided by its current liabilities are greater than for Company B. Also, taking these ratios over time may help show how a company’s financial position is changing.
Fundamental analysts also look at management, research and development expenses, earnings growth, stock price trends, customer concentration, or any other significant keywords you can find by searching through the available information. In addition to all this data, fundamental analysts also try to determine why the company has succeeded and what future opportunities exist for it. This helps them make educated guesses on what could happen next with a particular stock and why, providing insight into how an investment could turn out in the long term.
How to become a fundamental analyst
If you want to become a fundamental analyst, there are several steps you can take:
- Do your homework and learn about every aspect of investing and the markets (stocks/bonds/ mutual funds, etc.)
- Find a company that you believe to be undervalued or has potential
- Take the time necessary to analyze the company’s financial statements in-depth before making an investment decision
Fundamental analysis is about finding reliable information that can lead to educated guesses on how all of this data will affect a particular stock. When you fully understand what each piece of financial data means and how it fits into the bigger picture, the better able you will be to make solid investment decisions that lead to long-term success.