Fundamental analysis is the only technique to find high return generating stocks. It provide solid reasoning to buy sell or hold any stock or other financial instrument unlike technical analysis which is based on investors psychology and price movements alone. Almost all the investors who made to billionaire list are one way or other fundamental analyst.
But what actually we want to find from fundamental analysis?
Many jump into long and complex process of fundamental analysis of company without having any idea of what they want from that.
Here is the list of main objectives of fundamental analysis and why it is important before investing even a penny.
1. Find Undervalued Stocks
There are two ways to makes in one to buy thing (say 100$ )wait for any fool to come and buy this at higher than 100$. This theory is called as greater fool theory which is purely based on luck so have nothing to do with fundamental analysis.
Second is to find thing in market which is trading below its true value. For example a 100$ worth of ornament is selling at 75 $.
Is this even possible? The answer is big YES. Stock market is only the place where you can sell 100$ thing for 1000$ and you can even buy 100$ thing for 10$
Share prices are determined on the basis demand and supply. So prices are result of collective thinking of investors concerned in any way to that particular stock. But human mind is not always unbiased in thinking. It is often influences by emotions like greed, fear and hope. And also by the psychological tendencies like reasoning, wrong anchoring, blind faith in authority and many more.
Because of this sometimes prices differ vastly from its economic reality. This creates opportunity to buy stocks at price less than its actual value.
But the main question that might have raised in your mind is How the hell can I find this real/actual value?
That real value in technical terms is called as intrinsic value. And fundamental analysis of company is must to calculate such intrinsic value.
There are many models to find intrinsic value :
>> Discounted cash flow valuation.
>> Dividend discount models (Gorden growth Model)
>> Residual Income Models.
Most logical and prominently used among the above is discounted cash flow valuation. According to this intrinsic value of company is present value of all the cash flows that business is going to earn in its remaining life.
In short fundamental analysis provide tool to find undervaluation and overvaluation of companies in the market to find cheap stocks. It is most important in objectives of fundamental analysis.
2. Assess Risk In An Investment
Almost all the investment instrument have some kind of risk. It varies from instruments to instruments . For example stocks have more risk than government bonds.
Returns expected by investor is based on risk they are accepting. These returns excess returns than risk free rate of returns is called as risk premium.
With the help of fundamental investor can assess risk to know whether returns are justifiable.
Some common risk types are:
Volatility Risk : Risk that wild price fluctuations bring.
Geographical risk: Local laws, extent of ease of doing business, natural disasters, availability of skill labors, bureaucracy of local government etc.
Foreign exchange risk : If revenue or raw material of company is from foreign counties or investmet is made in foreign counties then change in exchange rate can harm returns.
Business risk : Risk of bad operating decisions, destruction of business model due to technological innovation and other such risks related to businesses.
Economical risk : Economy here is external environment in which business survives. Economic conditions have huge direct or indirect impact on returns from businesses. If economy is suffering from credit crisis then it will affect demand for products and credit availability to company.
3. Not To Fall Trap Of Psychological Tendencies
There are times in market when there is either over optimism or extreme panic. While working in live environment this put huge pressure on investor to follow the crowd.
This herd mentality is main causes of bubbles and panics.
In bubble market participants ignores facts or reality and make decisions solely on emotions. Bubbles eventually cause great loss to investors. But such mistakes can be avoided if every decisions is takes based on fundamental reasoning.
This also creates great opportunities in panics and stock market crashes.
In tech boom of late 90’s some newly established technology had achieved more market capitalization than companies like IBM and Ford. Which were operating nearly from century.
Some companies ware trading at price multiple of 400.
Almost all of these companies went to zero. Any investor could have avoided such kind of investment traps just with little fundamental analysis.
On the other hand.
After 9/11 in 2003 market was so depressed that some of the companies were trading at cash flow multiples of one or two. Which means you can buy whole company by paying its one year earnings.
The only way to find such extraordinary opportunities is deep stock analysis.
4. Future Projection And Analysis
Forecasting future is difficult and sometimes next to impossible thing. But long term trends are easy to identify. Like use of electric vehicles in future.
With the help of fundamental analysis investor can do such no brainer projections to find high return opportunities.
Past is not answer to the future all the time. But with the help of fundamental analysis and tracking economic changes investor can gain insight into foreseeable future.
Thus gaining ideas of possible future opportunities (tailwinds) and trends can be one of the objectives of fundamental analysis.
It is better to write your objectives from analysis on a piece of paper before starting process and then check at the end if answer of all is obtained.