Guide to fundamental analysis for trading

Fundamental analysis is a tool used by many investors, to find stocks they think are worth owning – either for years or shorter periods of time.

Whether investors are looking for companies to buy and hold, or comfortable collecting shorter-term gains, fundamental analysis begins by looking at key financial data found on a company’s financial statements. That may include revenue, debt, and cash flow, as well as ratios like earnings per share, debt to equity and more. This style of analysis can often incorporate earnings announcements, analyst upgrades and downgrades, stock splits, acquisitions, company news, as well as other broad economic indicators like inflation or interest rates and much more.

By comparing and contrasting these metrics with those of similar companies, fundamental analysis can help to assess the underlying strength or weakness of an asset to determine whether it could be a buy or a sell.

Fundamental analysis focuses on characteristics of the investment itself, while technical analysis focuses on patterns of investor behaviour. The former looks at key financial metrics, while the latter can include more varied indicators which look at ways to relate price movements with investor decisions to buy or sell. Pattern analysis, range trading, relative strength index – technical analysis indicators like these, use historical price and volume data to help investors determine what could come next. Technical analysis can seem complex, in part because there are so many indicators to consider. Knowing when to apply one indicator over another could depend on the investor's understanding of the specific circumstances around that company or sector.

Potential Benefits:

Informed decisions – Understanding the financial health of an asset is important, especially if you’re looking at it as a potential long-term, buy-and-hold investment.

Managing risk – Looking at fundamental factors may help you understand an asset’s value, such as whether a company has taken on excessive debt or is in poor financial health.

Potential Risks:

Market sentiment – Fundamental analysis assumes markets always work in a rational way, reflecting an asset’s intrinsic value. In fact, prices can deviate significantly from the fundamentals due to any number of reasons that may have little to do with a company.

Stale data – Fundamental investors rely on historical data, which can lag new developments happening within a company.

Complexity – Doing a detailed analysis can be complex and time-consuming and require a good understanding of financial statements and economic indicators. Having a good read on industry dynamics doesn’t hurt either.

Not all fundamental investors look for the same kinds of stocks. Different attributes and valuation methodologies may be preferred depending on the investor's goals and investment strategy. Many investors employ multiple fundamental trading strategies. Here are some of the most common:

Value investing seeks to find stocks that may be trading at a discount to their intrinsic value or the sector average. They don’t have to be outstanding performers, just stocks whose price is believed to be lower than the intrinsic value suggests and thus may rise over time. Avoiding overpaying for stocks may mitigate risk and could help contribute to better returns. Value investors consider a range of metrics such as price-to-earnings ratio, dividend yield, return on equity ratio, Free Cash Flow (FCF), etc.

Growth investors are willing to pay a premium price for stocks (as measured by today’s metrics) in the expectation that the company's sales and profits will grow in the future. This includes many technology stocks, which may not even be profitable yet, but growth stocks can be found in almost any sector. Like value investing, growth investors can spend a considerable amount of time researching companies, but they focus on using different financial ratios such as revenue growth rate, earnings growth rate, price-to-earnings growth (PEG), and forward price-to-earnings (forward P/E).

This is the practice of doing the opposite of the market consensus, in the expectation that markets may eventually revert to the mean. For example, contrarian investors may buy volatile energy and materials stocks when commodity prices are low and most other investors are piling into more popular technology and consumer stocks. Then, they’ll reverse course when the economic winds change.

Fundamental analysis seeks to identify stocks that have the potential to deliver above-average returns based on fundamental factors related to their market price, current and future expected profitability, revenue and earnings growth, debt, and macroeconomic trends. It involves doing research on potential equity investments.

Fundamental analysis studies the factors behind a stock’s value, whereas technical analysis focuses on historical price and volume patterns. Technical analysis focuses on investor behaviour, while fundamental analysis focuses on the investment itself.

Fundamental investing strategies include:

• Value investing (buying stocks believed to be cheaper than their intrinsic value or market/sector average)
• Deep value investing (buying distressed stocks believed to have turnaround potential)
• Growth investing (buying stocks believed to be most likely to grow earnings)
• Income/dividend investing (e.g., buying stocks with favourable dividend yields)
• Dividend growth investing (buying and holding stocks with a history of or commitment to raising dividends)
• Quality investing (buying stocks with a strong balance sheet and history of creating shareholder value)
• Contrarian investing (buying stocks in currently unloved sectors and selling stocks in popular sectors)

You can’t always predict the weather, but you can make some well-informed forecasts. Fundamental investors look at investing through the same lens. By understanding what’s affecting a company’s performance and looking at how it compares to similar companies, it may help improve stock market returns and mitigate risk.

It’s a popular approach, which also means there are many others out there trying to read the same numbers. All that competition can make it more challenging to find opportunities before anyone else does. Still, doing the research before hitting the “buy” button could help in finding companies with a bright outlook.