Investing Basics: Fundamental Analysis

One of the best things you can do for yourself when it comes to investing is to take a deep interest in your portfolio and the investments that you choose to invest in. Whether it’s a retirement account, a self-directed mutual fund or a desire to see what you can do in the stock market now that everything is on sale, it is important to have a grasp of the fundamentals underlying the companies you are considering. This idea of looking into the factors that provide the big picture of a company’s overall health is known as fundamental analysis. If you want to increase your chances of long-term investment portfolio success, it is important to analyze the investments you have or are planning to make– and to understand what makes them good (or poor) choices.

What is fundamental analysis?

Fundamental analysis goes beyond the daily ups and downs of a stock and focuses on the company behind the stock. Fundamental analysis is about looking at the way a company does business, how sound it looks and what the future prospects of the company might be. Some of the factors to consider when analyzing the fundamentals of a company include:

• Is the company making a profit? This can be a tough one to consider right now, since so many companies are not making profits due to the recession. But you can get a feel for a company’s performance by looking at what sort profits it was making before, and by looking into the reasons that the company’s profits have tapered off. And there are some companies that are still making profits, even during the recession. Focusing on these right now could be a good idea. Related to profits are whether or not margins are growing, and whether revenues are increasing. You should also consider the competitive landscape to understand if the profits can be maintained in the future.
• Can the company repay its debt? All companies have debt. It’s part of doing business. But you should look at how much debt the company has. And whether or not the company can repay its obligations. This can be done by carefully looking at the debt levels of the company, its cash flow and the amount of ‘interest coverage’, i.e. the ratio between the cash flow and the amount of interest the company owes on its debt in a year.
• Is there potential for growth? How likely is it that the company can maintain its position against or — even better — beat its competition? What are the future prospects for the company? Do you see potential for growth? Do the products and/or services offered offer quality or fulfill a need? Does the company adapt to the changing times? Can the company expand its market by selling globally?
• What is the management like? Does management try to do what’s best for the company? Also, be aware of whether the management is qualified and competent. Look for the accounting practices used by the company. Is management trying to “cook the books” with creative money shuffling? One of the ways to gauge how committed the management is to the success of the company is by looking at how much stock of the company does the management own as well as recent transactions. If you find that the management owns a large portion of the stock, and has been recently acquiring more stock, it is typically an indicator that the management believes that the company is well positioned for future growth and the stock price is attractive for investment. Having significant ‘skin’ in the game also ensures that the management will be focused on making decisions that increase shareholder wealth.

When you consider the fundamentals of a company, it is important to realize that there are quantitative issues and qualitative issues to consider. Quantitative issues are those that deal almost exclusively with numbers. This is looking at the way money flows through the company, understanding balance sheets and income statements, and considering the assets v. liabilities of a company in cold, hard numbers terms. The qualitative side of fundamental analysis requires that you look at the intangible aspects. What is the character of the company? Qualitative fundamental analysis requires that you look at the caliber of the management team and the ethical standards upheld by the company. Competitive advantage and the business model of the company are also qualitative factors.

Using fundamental analysis to make long-term investing decisions

Fundamental analysis is often used by buy and hold investors who want to own stock in companies that have long-term earning potential. A company with sound fundamentals and conservative accounting is more likely to be profitable in the long run. These are companies that make solid decisions that prepare them to survive economic down cycles and thrive afterward. A company with good capitalization, positive cash flow, a well-thought out business model and a management that is intelligent, competent and ethical is more likely to survive and offer solid returns over time. Of course, such companies also offer lower returns than some of the flashier companies. You trade the possibility of astounding short-term earnings for long-term solidity and a greater degree of security.

Fundamental analysis can be used for more than just choosing stocks to invest in. It is possible to apply the big picture analysis to wider trends in economies, industries and sectors. Fundamental analysis can also be applied to funds, currencies and commodities.