In terms of the stock market, fundamental analysis talks about the, well, fundamentals of a company.
What the heck are fundamentals?
In a nutshell, “fundamentals” refer to all the factors that may affect the company that issues the stock. There are two types of fundamentals:
- Qualitative factors
- Quantitative factors
Qualitative factors are those that you can’t count (but there’s still a good dose of math involved, unfortunately). Rather, they’re the intangible ‘qualities’ of a business.
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Major Financial Statements
The most important financial statements you must look at include:
- The balance sheet
- The income statement
- Statement of cash flows
- The Cash flows from operating activities
- Cash flows from investing activities
- The Cash flows from financing activities
- 10-K and 10-Q
- Management discussion and analysis (MD&A)
- Auditor’s report
The Concept of Intrinsic Value in Fundamental Analysis
Fundamental analysis also revolves around the concept of intrinsic value—the real value of a company’s stock.
For fundamental analysts, the stock market doesn’t always fully reflect the true value of a stock. And that’s where you can play on the price of the stock.
- Undervalued stocks are those that cost lower than their intrinsic value.
- On the other hand, overvalued stocks are those that cost higher than their intrinsic value.
Here’s an example:
You want to invest in stock A, whose current market price is $10. You perform fundamental analysis to find out if it’s undervalued or overvalued.
After careful analysis, you figure its intrinsic value is $20, or double its market price. This means that the stock is a good buy. It’s undervalued, meaning there’s a chance its price will appreciate in the future.
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Buy Low, Sell High
Because of the factors they consider, fundamental analysts follow the concept of buying low and selling high. Typically, they search for undervalued stocks and go long on them.
When the market finally reflects the real value of the stock, and when all the fundamentals are topping out, they cash in by selling the stock for a higher price.