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Fundamental analysis is a type of stock selection discipline. If you conduct thorough research of a company's accounting statements before deciding to purchase stock in the company for investment purposes, you are said to be following a fundamental analysis approach to investing. Another very common approach is technical analysis, which is almost the opposite type of approach.
A fundamental analysis approach attempts to determine whether the company is financially sound and will continue to earn money. A technical analysis approach to investing is almost entirely concerned with how the price of the stock has performed over time and attempts to predict what it will do in the future based on this. Sometimes, the two approaches are combined, with a fundamental analysis approach used to select the stocks and a technical analysis approach used to time the investment in the stocks of interest.
When performing a fundamental analysis of the stock of interest, one tries to determine whether the stock is worth investing in. In this approach, one looks at how well the company is performing financially. What are the company's earnings? Have they been growing? How does the ratio of the price of the stock versus the earnings per share, the P/E ratio, compare with other similar companies?
This approach attempts to answer some basic or fundamental questions about the financial health of the company and the industry in which the company operates. How large is the company? How long has it been in business? What is the management of the company like? What is the outlook for the industry that the company is in?
Fundamental analysis is usually viewed as a more conservative approach to stock selection than technical analysis. It is certainly a more exact science. The price earnings ratio is easy to calculate; it is simply the price of each share of the stock divided by the earnings per share. The book value of the company can easily be determined from the company's financial statements, and the earnings are easily calculated from the financial records.
In contrast, the mathematics behind most technical analysis is much more complex and frequently requires much more of a judgment call on the part of the investor. In a technical analysis approach, the investor attempts to predict crowd behavior, while a fundamental analysis simply attempts to determine whether the company has been earning money and at what rate it will likely continue to earn money. The price of the stock in the short term is not that important in a fundamental analysis, since the theory is that if the company is earning money and continues to earn money, then the stock price will eventually go up. A technical analysis approach is much more concerned with short term price movements.
Investing in stocks is much more likely to be successful if a systematic approach is used. A fundamental analysis approach is the easiest to understand and learn, and as such, it is perhaps the best place to start for a beginning investor. However, both approaches have their strengths, and knowledge of both will benefit any investor and result in improved investment returns.
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