The use of the fundamental analysis approach in trading has long been an object of argument between its followers and those who question the method's effectiveness in determining a stock's intrinsic value. Rather than taking sides in this argument, we'll instead focus on how a trader can benefit from fundamental analysis. We'll discuss the strengths and weaknesses of fundamental analysis as a trader's tool, highlighting those situations where a trader can employ fundamental techniques to make investment decisions.
- Traders who use fundamental analysis to perform a stock evaluation review data related to the current economic environment, the company's financial health, and the company's competitors.
- Traders use the data they uncover to determine a stock's intrinsic value.
- By determining if a stock is undervalued, overvalued, or correctly priced, a trader can evaluate the stock for its potential as a profitable investment.
- Traders sometimes combine fundamental analysis with technical analysis to help them pinpoint when and how to make their investment decisions.
The Mechanics of Fundamental Trading
The fundamental approach for valuing a company is based on an in-depth study of the economy, the industry in which the company operates, and the company itself. The trader uses the data from this analysis to forecast market developments and to determine the intrinsic value of the company's stock.
The trader can also use fundamental analysis as a tool to help predict the future value of the stock and to determine if the stock is overvalued or undervalued. A successful analysis can uncover investment opportunities not yet recognized by the market as a whole and can assist the trader in making a profitable investment.
Methodologywise, the trader can opt to use different approaches as part of the fundamental analysis of a stock. For example, the trader can choose to compare industry groups with other industry groups, or companies within those groups against each other.
Examples of Fundamental Analysis in Trading
A trader's ability to successfully apply fundamental analysis depends on a number of factors. A good starting point is to consider the potential profit of the targeted trade. It's important to understand the various ways fundamental analysis can help you identify potentially profitable trades and to understand why these trades could be profitable.
Here are two examples of how you could use fundamental analysis to identify potentially profitable investments.
Established companies, mutual funds, and other large financial organizations make big moves in the financial markets and can act as portfolio builders for investors. In this case, a trader's profit will act as compensation for the risks taken.
There are many ways you can use fundamental analysis to determine if an investment in an established publicly-traded stock has the potential for profit. The goal is to weigh all the different information that can affect the stock's price.
First, traders will look at the current economic environment, which includes domestic and global events that could affect the company and its stock price. For example, are there any regional conflicts (such as wars or labor strikes) that could affect the company's ability to acquire materials needed for production? Are there macroeconomic factors that impact the company's pricing structure, such as increasing interest rates or inflation? What is the forecast for the company's industry as a whole? Are there disruptive factors that could negatively impact the niche in which the company operates?
The next step in a fundamental trading analysis is to conduct extensive research on the company itself. It's important to have a clear understanding of the company's business model and how it makes its money. Traders will review the company's financial statements, examining its cash flow statements, income statements, and balance sheets for at least the past two years. During this review, the trader will be looking for clear signs of growth, effective management that can counteract any negative macroeconomic factors, and any competitive advantage the company has that could propel future growth.
Lastly, the trader will analyze the company's competitors in a fashion similar to the fundamental analysis already conducted for the company. The trader will compare findings for both the target company and its competitors to rank all the companies as potential investments. At this step of the fundamental analysis, the trader may discover the company offers good investment potential or a competing company offers better potential. Or, upon reflection, the trader may decide that none of the stocks reviewed would be good investments at this time.
Initial Public Offerings
An initial public offering (IPO) can provide traders with an opportunity to cash in on the discrepancy between the IPO price of the stock and the price at which it will eventually settle. As a trader, your earnings will be your compensation for the risk you take on.
While traders can use many of the fundamental analysis techniques outlined above, these alone may not be enough to fully evaluate the profit potential of an IPO. IPOs can have risk factors that a fundamental analysis may not be able to measure. For example, it can be challenging to do a fundamental analysis for IPOs in relatively new industries as there is little historical data about that industry for review and comparison purposes.
Also, the price of an IPO stock is sometimes inflated due to intense media coverage. Some investors are affected by herd instinct and invest in an IPO without performing research and due diligence. This can lead to an initial elevated stock price, one that rapidly declines after the stock begins to trade.
Fundamental analysis is generally not used as a tactical, short-term decision-making method. Technical analysis enables traders to gain a vision of the market and make the right move at the right time, while fundamental analysis should be applied strategically, over longer periods.
Fundamental analysis helps a trader obtain information about the overall state of the market and attractiveness of a specific security as compared to other securities. However, some investors prefer to use technical analysis to pinpoint when and how to react to the information derived through fundamental analysis.
Compete Risk Free with $100,000 in Virtual Cash
Put your trading skills to the test with our FREE Stock Simulator. Compete with thousands of Investopedia traders and trade your way to the top! Submit trades in a virtual environment before you start risking your own money. Practice trading strategies so that when you're ready to enter the real market, you've had the practice you need. Try our Stock Simulator today >>