A billion dollars is a large number regardless of how you see it. If you had to spend $10,000 a day, it will take you 2,740 years to spend a billion dollars. That is a long time and a lot of money to spend on each day.
How about a Trillion dollars? A trillion dollars, is a billon dollars a thousand times and at the time of writing, there are over five companies that have a market capitalisation that exceeded $1 Trillion dollars.
As an investor what does this actually mean and how can it enable you make better decisions? Let us first look at what a company’s market capitalisation is. The market capitalisation of a stock is the number of outstanding shares multiplied by the price of a share.
This is where things get interesting as an investor because it begs the question, is the company in question really worth $1 trillion dollars? The price of a stock is what two parties agree to trade it for but that does not say much about how much the company is worth.
When you buy a stock, you own equity or a piece of that trillion dollar company. That must be a satisfying feeling however how much value can you get while you own that stock and after you choose to sell it?
Fundamental analysis allows you to fundamentally analyse a company in order to determine what it is actually worth. The process of carrying out fundamental analysis includes looking at reports and filings and other aspects of a company to determine what it is worth.
Applying this strategy, the price only serves as a benchmark to help you determine if the company is over priced or undervalued. Apart from that, you pay very little attention if any to the price of the stock as it is more of a distraction.
In this article we will look at what fundamental analysis is and why it is important for to an investor.
Fundamental Analysis Definition
Fundamental analysis can be defined as a process of gathering information on a company, analysing the information for the purpose of making an investment decision.
Accountants and auditors can look at a company’s book, asset and liabilities to determine if the company is in good shape. The main difference here is that with fundamental analysis you are looking to make an investment decision off the back of the results from the investigation.
It goes beyond coming to a conclusion that the company in question is in good financial shape; it goes further to look at factor like the management, the products and even the economic conditions in which the company operates.
Fundamental analysis is the close study of different aspects of a company such as financial reports, management team, income statement, balance sheet and cash flow statement in order to have a clear picture of what a company is worth.
There are different ways to approach this so let us consider a very basic form of this. If we divide what we are looking for into three parts, we can see a clear picture.
- How does cash come into the company.
- How is the cash spent within that company.
- How is the cash that comes out of the company spent.
When more cash comes into a company that is a good sign; it can mean the products or services are selling well and customers love it. It is a sign the company is growing and expanding and ultimately this is positive news for an investor. The Income Statement gives insight into this aspect of the company.
For a company to sell its products, money has to be spent on researching and developing the product. Additionally the team that markets the products, manages logistics and delivery are part of the process of getting the product to market and also incur some costs.
There are financial ratios and other figures we can look at that will help us understand how the financial resources are spent within the company and if we are getting a good return on investment.
After the money has been made, how much of it does the company keep and what portion it is re-invested? Behind all this is a management team making decisions that will affect the value of your investment.
The important thing to remember is that when you purchase a stock, you own a share of the company and that is an amazing thought in itself. It also carries responsibilities and unless you like to throw your money and time away as an investor, it is necessary to take time to analyse a company in detail before investing.
Why is Fundamental Analysis Important
Any form of analysis is important because it allows you to see in detail and better understand what you are looking invest in.
Let’s say you are buying a house for example; as an investor, you want to add a new residential property portfolio. How will you go about it? I am certain you will not simply buy a property for the price it is listed at.
Ideally you will look at the area, see how much three or four bedroom properties sell for in that area, determine the finishing standard of the property. Is there a shed, loft or conservatory, garden or anything else that can potentially add more value.
Fundamental analysis is obviously different but the principle is the same and as an investor you are looking at companies where you can invest your money and get a return on your investment and eliminating any speculation in that process.
Fundamental analysis allows you to approach investing with hard numbers and facts rather than being impulse driven or going off tips from your uncle’s brother’s friend’s sister’s cousin.
Speculators look at the price of an asset and determine if it can be sold for a higher price without taking any fundamental analysis into account. As we mentioned earlier, the price is simply what two parties agree to exchange a product for.
The price gives no indication of the actual value of the product in question and this is why fundamental analysis is important because you are looking beyond the price.
Different types of participants carry out fundamental analysis and each of them has a reason why they do fundamental analysis.
Bond holders for example will do fundamental analysis to ensure that the company will be around long enough for them to recover what they have invested in it, and the yield over that time.
When a company issues a Bond, the buyer of the bond will expect to get their initial invested money returned after the set period of time expires with any interest on a yearly basis. If the company falls apart or goes bankrupt, the bond holders will be left holding thin air.
Employees can do fundamental analysis in the company they work in and there are a number of reasons why they will do so and benefits from doing that. Employees can see which parts of the business is growing or where future opportunities are. Employees can negotiate a better pay package too if their unit performs well.
Investors that trade ETFs or any Index funds can benefit from fundamental analysis because it can reveal with companies that will be added or removed from an Index and this presents opportunities.
Depending in your investing strategy, you may choose to do fundamental analysis and focus on companies that meet a certain criteria. If you are looking to invest in companies that are growing fast or growth stocks, you will focus more on certain aspects of the company.
If your focus is dividend yield, you may focus on other aspects of the company but in both cases, you still carry out fundamental analysis to get a closer look into how the company is doing regardless of what the price may indicate.
Summary
The process of carrying out fundamental analysis allows you to gain an insight into how a company works, what the financial health of the company is, how competent the management is in comparison with their peers and how much of a future the company has.
The outcome of this process should be a clear understanding of how this company stacks up and if it is worth you investing your hard earned money – and time not to mention.
Fundamental analysis significantly reduces any knee-jerk attitude to investing in a company. These days it is easy to get caught up in the hype of a stock and this can come from a number of places; channels that show financial tickers rolling across the screen are not necessarily there to educate but to entertain.
Fundamental analysis allows you to understand the company behind the ticker. It presents an opportunity to look closer at the products the company produces, the team running the show, how the customers are reacting to the products and overall the value of the company.
It is an essential part of the process of deciding what company to invest in, how much and for how long. Other methods to analysis which we cover here focus on other aspects of the market and trends rather than the underlying company.
Some people may treat the stock market as a casino and in some cases it works for them but in the end the house always wins. As a serious Investor, fundamental analysis gives you a chance to participate in the market and win not by speculation but studying the fundamentals of the company.
