What comes to mind when you hear the expression “more than meets the eye”? Maybe it’s that car for sale down the street that’s full of rust on the outside but still has a great engine under the hood. Or the house that just hit the market—sure it might need a new paint job, but it’s got a solid foundation.
The same can be true for some investments and stocks. What they’re currently worth on the market might not be a true reflection of what they’re actually worth. How can an investor tell? That’s where fundamental analysis might come in handy!
What Is Fundamental Analysis?
Fundamental analysis gives investors a way to figure out the true value of an investment (usually a company’s stock) to decide if it’s worth investing in.
Fundamental analysts do this by studying a wide range of economic factors and data—including the company’s financial statements, economic reports and industry trends. This information is what fundamental analysts call . . . wait for it . . . the fundamentals.
The Basics of Fundamental Analysis
One of the main ideas behind fundamental analysis is that an investment’s current price on the stock market usually isn’t an accurate reflection of what it’s really worth. So, the goal of fundamental analysis is to find out the investment’s true value (also known as its intrinsic value) and compare that against how much the investment is currently worth on the stock market. That way, investors can see whether the investment is currently undervalued or overvalued.
Fundamental analysis is the foundation of an investing strategy known as value investing, where investors search for investments that are priced lower than what they’re “really” worth and buy them while the price is down. Why? Because fundamental analysts believe the investment’s market price will eventually reflect its true value—it’s just a matter of time.
For example, let’s say a company’s stock is currently selling for $5 per share on the stock market but fundamental analysis estimates that stock’s true value is really $15 per share. Value investors might look at that analysis and buy some shares of the stock, thinking the stock’s market price will eventually match its true value. If it does (and that’s a big if), those investors can sell it for three times what they bought it for.
The opposite is also true. If fundamental analysis shows that an investment’s true value is lower than its stock market price, a fundamental analyst will probably recommend selling high or avoiding that investment altogether.
Criticisms of Fundamental Analysis
But hold the phone for a minute! Not everyone is on board with the fundamental analysis approach to analyzing stocks and investments.
There are some investors who use technical analysis—which means they prefer to ignore the fundamentals and focus on what the stock is doing right now. They’re more worried about what direction a stock is moving and how much of that stock is being bought and sold on the market. For them, it’s all about buying and selling based on momentum—not fundamentals.
Still, fundamental analysis plays a huge role in the decision-making process for many investors, so it’s worth understanding how it all works.
How Does Fundamental Analysis Work?
Depending on who’s doing the fundamental analysis, different analysts will look at different sets of data and come to different conclusions about a stock’s true value. But in general, fundamental analysts usually look at three things when analyzing the true value of an investment like a company’s stock:
- The overall state of the economy
- The industry the company is in
- The company’s finances and overall health
The idea is that when you analyze these three factors and put them altogether, it’ll give you a clearer picture of that company’s true worth. Let’s break each of those down one by one.
Step 1: Look at the Economy
The first thing fundamental analysts do is look at the big picture. They look at how many jobs were added or lost in the most recent job report. They look at what direction the stock market is headed. And they also look at interest rates, inflation and a whole host of other economic indicators that might impact the overall economy.
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Why? Because this is the environment that all companies have to live in, and it might impact how a company’s stock will perform in the future. If no one’s buying anything because the economy’s in bad shape, that might hurt a company’s stock value.
Step 2: Understand the Industry
Next, fundamental analysts will take some time to learn more about the industry the company is in. If a fundamental analyst is trying to analyze the true value of a tech company, that means they’ll look at the tech industry through a microscope to see where it’s moving. Is the industry growing? Or is it shrinking? How does the company measure up against its competitors? Is the company staying ahead of the curve with the latest innovations or are they falling behind? These are some of the questions fundamental analysts try to answer in their analysis.
Step 3: Study the Company
And last, but certainly not least, it’s time to look at the company itself. Fundamental analysts love looking at data. They’ll dig deep into all of the company’s financial statements—things like balance sheets, income statements and cash-flow statements—to get an idea of the financial health of the company behind the stock.
But they won’t stop there. They’ll also study other factors that aren’t as easily measurable but can give investors a more complete understanding of a company’s true value—things like the company’s management team, business model and brand recognition.
The Key to Successful Investing
While fundamental analysis might be good information to help you decide whether or not to invest in something, it’s not always foolproof. Even the experts get it wrong sometimes, so don’t treat fundamental analysis as gospel!
Regardless of how you feel about fundamental analysis, remember that investing is a marathon, not a sprint. That means you need to take a long-term perspective to investing that helps you ride the ups and downs of the stock market.
And no matter how much faith you have in fundamental analysis, buying a single stock here and a single stock there isn’t going to help you reach your investing goals. You need to diversify your investments—which simply means you’re spreading your investments out and reducing your risk.
That’s why we recommend investing in good growth stock mutual funds, which usually have stocks from dozens of different companies across different industries inside them. Investing in mutual funds gives you a built-in layer of diversification!
To diversify your investments even further, you should invest evenly between four types of mutual funds: growth, growth and income, aggressive growth, and international. That way, you can reduce your risk while still reaping the benefits of investing in the stock market. That’s a win-win!
Work With a Financial Advisor
If you want to take most of the guesswork out of investing, the best way to do that is to work with a qualified financial advisor. We can help you find one through our SmartVestor program, which connects you to financial advisors in your area.
Not only can they walk you through complex investing concepts (like fundamental analysis), but they can also give you options to help you invest for the future.
Ready to get started? Find your financial advisor today!
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This article provides general guidelines about investing topics. Your situation may be unique. If you have questions, connect with a SmartVestor Pro. Ramsey Solutions is a paid, non-client promoter of participating Pros.